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THE  MACMILLAN  COMPANY 

NEW  YORK    •    BOSTON   •    CHICAGO  •    DALLAS 
ATLANTA  •    SAN   FRANCISCO 

MACMILLAN  &  CO.,  Limited 

LONDON  •    BOMBAY  •    CALCUTTA 
MELBOURNE 

THE  MACMILLAN  CO.  OF  CANADA,  Ltd. 

TORONTO 


FOREIGN  EXCHANGE 


A  STUDY  OF 

THE   EXCHANGE   MECHANISM 

OF  COMMERCE 


BY 


HARRY   GUNNISON   BROWN 

ASSISTANT   PROFESSOR   OF   ECONOMICS    IN   THE   UNIVERSITY 
OF    MISSOURI 


THE   MACMILLAN   COMPANY 
1920 

All  rights  reserved 


V 


'5>b'13  54 


Copyright,  1914, 
By  the  MACMILLAN  COMPANY. 


J.  8.  Gushing  Co.  —  Berwick  A  Smith  Co. 
Norwood,  Mass.,  U.S.A. 


PREFACE 

This  small  volume,  also  published  as  Part  I  of  my 
International  Trade  and  Exchange^  deals  chiefly  with 
the  subject  of  Foreign  Exchange,  though  it  also  contains 
two  introductory  chapters  on  Laws  of  Money  and  The 
Nature  of  Banking,  which,  in  my  judgment,  make  pos- 
sible a  clearer  understanding  of  the  economic  theory  of 
foreign  exchange  operations.  In  these  and  the  follow- 
ing chapters,  I  have  endeavored  to  analyze,  more  fully 
than  is  usually  done,  the  interrelations  of  different  per- 
sons, buyers  and  sellers,  et  al.,  in  the  credit  mechanism 
of  exchange, — to  show  who  are  the  ultimate  creditors 
when  bank  checks  and  bank  notes  are  used  in  trade  and 
when  bills  of  exchange  (especially  "  long  bills ")  are 
used.  Thus,  after  the  explanation  of  the  nature  of 
banking,  the  reader  is  led,  in  Chapter  III,  The  Nature 
and  Method  of  Foreign  Exchaiige,  to  an  appreciation  of 
the  international  nature  of  the  credit  relations  growing 
out  of  trade.  The  flow  of  money  from  country  to  coun- 
try having  been  explained  briefly  in  Chapter  I,  the 
relation  of  this  flow  to  the  rate  of  exchange  and  to 
fluctuations  in  the  rate  of  exchange  is  set  forth  at  length 
in  Chapter  V.  In  the  last  chapter  emphasis  is  placed 
on  the  fact,  ordinarily  passed  without  mention,  that 
whatever  may  be  the  relation  or  non-relation  of  the  cur- 
rency of  a  country  to  the  currencies  of  other  countries, 
its  trade  with  them  cannot  all  be  either  an  export  or  an 
import  trade  for  any  great  while,  without  introducing  a 


vi  PREFACE 

tendency  to  a  reverse  flow  or  to  equilibrium.  Since  this 
last  chapter  was  written,  the  outbreak  of  the  European 
war,  and  the  consequent  risk  and  cost  of  shipping  gold, 
have  given  practical  significance  to  a  discussion  which 
would  perhaps  have  appeared  to  be  theoretical  and 
academic. 

Acknowledgment  should  be  made  here  of  various 
courtesies  extended,  and  of  the  aid  rendered  by  a  num- 
ber of  friends  who  have  done  much  toward  removing 
errors  of  statement  and  expression  and  in  suggesting 
critical  and  illustrative  additions.  To  the  Quarterly 
Journal  of  Economics  I  am  under  obligation  for  per- 
mission to  include,. in  Chapter  II,  substantially  without 
change,  an  article  on  Commercial  Banking  and  the  Rate 
of  Interest^  originally  published  in  August,  19 lo.  To 
Brown  Brothers  of  New  York  I  am  indebted  for  in- 
formation on  a  number  of  special  points  regarding  for- 
eign exchange.  '  To  one  of  my  students,  Mr.  Lawrence 
M.  Marks,  Yale  19 14,  I  am  indebted  for  the  calculation 
of  seasonal  sterling  exchange  rates,  presented  in  a  foot- 
note of  Chapter  IV,  Section  2.  Mr.  Franklin  Escher, 
of  New  York  City,  formerly  editor  of  Investment,  has 
given  me  the  benefit  of  a  careful  criticism  of  the  manu- 
script, particularly  regarding  the  matter  of  conformity 
of  statement  to  business  practice.  To  Professor  F.  R. 
Fairchild  of  Yale  College  I  am  indebted  for  a  search- 
ing criticism  from  the  standpoint  both  of  theory  and  of 
form.  Finally,  I  would  acknowledge  here  the  obliga- 
tion I  am  under  to  my  wife,  who  has  given  me  valuable 
assistance  in  reading  and  criticizing  the  manuscript  in 
its  various  stages  of  completion,  and  in  correcting  the 
proof. 

HARRY   GUNNISON   BROWN. 

MiLFORD,  Connecticut. 


CONTENTS 

VAGBS 

Chapter  I  —  Laws  of  Money 1-25 

§  I .  Quantitative  Statement  of  the  Relation  between  Money 
and  Prices 

§  2.  Causal  Explanation  of  the  Price  of  a  Given  Kind  of 
Goods 

§  3.   Causal  Explanation  of  the  General  Level  of  Prices 

§  4.  Causal  Explanation  of  the  Value  or  Purchasing 
Power  of  Money,  the  Reciprocal  of  the  Level  of 
Prices  of  Goods 

§  5.   The  Theory  of  Bimetallism 

§  6.   The  Value  of  Subsidiary  Money 

§  7.  The  Value  of  Money  as  Related  to  the  Value  of  a  Stand- 
ard Money  Metal 

§  8.  The  Level  of  Prices  and  the  Value  of  Money  in  One 
Country  or  Locality  as  Related  to  the  Level  of 
Prices  and  the  Value  of  Money  in  Another 

§  9.    Summary 

Chapter  II  —  The  Nature  of  Bank  Credit    .        .         26-50 
§  I.   How  and  When   Credit   Takes   the  Place   of  Money 
§  2.    How  Commercial  Banking  is  Carried  On 
§  3.   Analysis  of  Relations  Involved  in  Commercial  Bank- 
ing 
§  4.   Why  Commercial  Banking  Commends  Itself  to  Busi- 
ness Men,  both  as  Lenders  and  Borrowers,  so  that 
Commercial    Bank    Credit    becomes     a    Substitute 
for  Money 
§  5.   Application  of  Principles  Arrived  at,  to  Bank  Notes 
§  6.   Quantitative    Statement    of   the   Relation  of  Money, 
together  with  Bank  Credit,  to  Prices 


viii  CONTENTS 

§  7.   Fluctuations  of  Bank  Credit 
§  8.    Summary 

Chapter  III  —  The  Nature  and    Method   of  Foreign 

Exchange 51-76 

§  I .   The  Function  of  Bills  of  Exchange 

§  2.    The  Nature  of  Bills  of  Exchange 

§  3.  How  Bills  of  Exchange  Might  be  Used  to  Settle  Obli- 
gations, Assuming  no  Banks 

§  4.  Settlement  of  Obligations  by  Drafts  (Bills  of  Ex- 
change), through  Intermediation  of  Banks,  Assum- 
ing Creditors  to  Draw  Drafts  on  Debtors 

§  5.  Settlement  of  Obligations  by  Bank  Drafts,  when 
Debtors  Remit  to  Creditors 

§  6.   How  Exchange  Banks  Make  Profits 

§  7.    Various  Types  of  Drafts 

§  8.  The  Sale  of  Demand  Drafts  against  Remittances  of 
Long  Bills 

§  9.   Summary 

Chapter  IV  — The  Rate  of  Exchange  .        .        .       77-102 
§  I .   The  Meaning  of  Par  of  Exchange 
§  2.    The  Supply  of  and  the  Demand  for  Bills  of  Exchange 
§  3.    The  Effect  on  the  Exchange  Market  of  any  Country 

of  Disturbed   Political   or  Industrial   Conditions   in 

That  Country,  and  in  Other  Countries 
§  4.   Analysis  of  the  Relations  Involved  in,  and  Explanation 

of  the  Results  of.  Short  Time  Loans  Made  Ostensibly 

by  Foreign  Banks,  through  the  Intermediation  of  the 

Exchange  Market 
§  5.    Finance  Bills,  What  they  Are,  Whose  Accumulations 

Make  them   Possible,  and   What  are  their   Results 
§  6.    How  a  Bank  in  One  Country  and  a  Bank  in  Another 

May,   through   the   Aid   of  the  Exchange   Market, 

Invest  in  One  of  the  Countries  for  Joint  Account, 

without  Either  Bank  Using  its  Own  Funds 
§  7.    Analysis  of  the   Relations   Involved    in   a   Letter  of 

Credit 
§  8.   Place  Speculation  or  Arbitraging  in  Exchange 


CONTENTS  IX 

FAGBt 

§  9.   Time  Speculation  in  Exchange 
§  10.    Summary 

Chapter  V  —  The  Rate  of  Exchange  and  the  Flow 

OF  Specie 103-125 

§  I.  The  Upper  Limit  to  Fluctuation  of  the  Rate  of  Ex- 
change, Determined  by  the  Cost  of  Exporting 
Specie 

§  2.    Some  Details  Connected  with  the  Exportation  of  Specie 

§  3.  The  Lower  Limit  to  Fluctuation  of  the  Rate  of  Ex- 
change, Determined  by  the  Cost  of  Importing 
Specie 

§  4.  Circumstances  which  May  Cause  the  Rate  of  Exchange 
to  Fall  Below  What  is  Usually  its  Lower  Limit 

§  5.   The  Cost  of  Money  Shipment  in  Domestic  Exchange 

§  6.  The  Long  Run  Effect  of  a  Balance  of  Payments  from 
One  Country  to  Another,  for  Commodities  or 
Services 

§  7.  The  Long  Run  Effect  of  International  Investments 
upon  the  Rate  of  Exchange  and  the  Flow  of  Money 

§  8.  The  Long  Run  Effect  of  Various  Other  Payments  from 
One  Country  to  Another 

§  9.    Summary 

Chapter  VI  —  Further  Considerations  Regarding  the 

Rate  of  Exchange 126-154 

§  I .   The  Price  of  Long  Drafts  Determined  in  Part  by  the 

Rate  of  Interest  or  Discount 
§  2.   How  Long  Drafts  on  Foreign  Countries  are  Held  as 

Investments  by  American  Banks 
§  3.   Influence  on   the   Price  of  Long  Drafts,   of  Interest 

Rate  in  Drawing  Country  and  of  Interest  Rate  in 

Country  Drawn  Upon 
§  4.   How  and  Why  the   Bank  Discount  Rate  Affects  the 

Price  of  Demand  Drafts  and  the  Flow  of  Specie 
§  5.    Effect   of  a  Panic  in  One  Country  on  Conditions   in 

Other  Countries 
§  6.   Exchange  between   Two  Countries  when  One  has  a 

Gold  and  the  Other  a  Silver  Standard 


CONTENTS 

§  7.  Exchange  between  Two  Countries  when  One  has  a 
Gold  and  the  Other  an  Inconvertible  Paper  Stand- 
ard 

§  8.  Exchange  between  Two  Countries  when  Both  have 
Inconvertible  Paper  Standards 

§  9.  Exchange  between  Two  Countries,  Assuming  Effec- 
tive Prohibition  of  Specie  Shipment 

§10.  The  Effect  on  the  Rate  of  Exchange  of  High  Im- 
port and  Export  Duties 

§11.   Summary 


INTERNATIONAL  TRADE 
AND  EXCHANGE 

CHAPTER   I 
Laws  of  Money 


Quantitative  Statement  of  the  Relation  between  Money  and 

Prices 

Primitive  trade  is  often  a  direct  trading  of  one  kind 
of  goods  for  another,  the  process  called  barter.  The 
exchange  of  knives,  hatchets,  guns,  mirrors,  etc.,  with 
the  Indians,  in  return  for  land  and  furs,  with  which  we 
have  been  made  familiar  in  our  school  histories  and  in 
stories  of  adventure,  was  trade  of  this  sort.  But  even 
the  Indians  had  wampum,  which  they  used  as  a  medium 
of  exchange,  and  the  highly  civilized  countries  have 
long  since  made  use  of  money,  whether  of  gold  or  silver 
or  other  material,  in  their  commerce.  A  study  of  the 
laws  of  commerce  involves,  then,  and  may  well  involve 
as  a  preliminary  step,  a  study  of  the  laws  of  money. 
We  are  not  likely  to  find  that  the  basic  principles  of  trade 
are  so  very  different  with  money  used  than  they  would  be 
if  the  world  traded,  supposing  it  conveniently  could, 
goods  of  one  kind  directly  for  goods  of  another.    The 


2    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

moniey-using' method  of  trade  is  more  efficient.  The 
motives:  ipjr'tlrafJe  ^d.tlie'nature  of  the  advantages  from 
it  are  the  same'wlietKef  money  is  used  or  not.  But  it 
is  worth  while  analyzing  the  commercial  processes,  as 
they  are  actually  carried  on,  even  in  many  of  their  mod- 
ern complications.  To  do  so,  may  perhaps  the  more 
clearly  elxpose  fallacies  regarding  trade,  not  uncommonly 
held.  We  shall  begin,  then,  with  a  study  of  money, 
considered  as  an  important  part  of  the  mechanism  of 
trade. 

Money,  as  a  medium  of  exchange,  is  a  kind  of  wealth 
or  property  for  which  other  goods  are  sold  and  with 
which,  in  turn,  desired  goods  are  bought.  It  may  be 
distinguished  from  other  wealth  or  property  by  its 
characteristic  of  general  exchangeabihty.  A  person 
desiring,  as  all  do  desire  who  are  engaged  in  any  business 
or  regular  occupation  or  who  have  capital  to  invest,  to 
dispose  of  some  kinds  of  goods  or  services  in  exchange 
for  others,  does  not  need  to  seek  out  those  who  both  want 
what  he  has  to  sell  and  will  sell  what  he  wants  to  buy  and 
with  whom  he  can  make  a  satisfactory  trade  ''in  kind." 
Instead,  he  sells  for  money,  for  a  universally  desired 
medium,  what  he  has  to  dispose  of,  to  whoever  desires 
it,  and,  with  this  money  as  purchasing  power,  seeks  out 
those  who  have  for  sale  what  he  himself  wishes  to  buy. 
The  use  of  money  is  an  intermediate  step  in  what  is  still 
the  exchange  of  goods  for  goods.  In  order  that  money 
may  perform  its  function  of  faciHtating  trade,  both  goods 
to  be  sold  and  goods  to  be  bought  must  be  valued  in 
terms  of  money.  Money  becomes  a  measure  of  value 
as  well  as  a  medium  of  exchange.  One  kind  of  goods 
will  have  a  higher  value,  measured  in  money,  than  an- 
other kind,  if  its  cost  of  production  is  greater,  or  if,  for 


LAWS  OF   MONEY  $ 

any  other  reason,  only  the  higher  value  will  equalize 
supply  of  and  demand  for  this  kind  of  goods.  The  same 
relation  of  values,  between  two  sorts  of  goods,  would 
exist  if  money  were  not  used,  but  the  use  of  money  makes 
it  measurable  in  a  generally  familiar  standard. 

An  analysis  of  the  prices  or  values  of  one  sort  of  goods 
as  compared  with  those  of  other  sorts,  leads  us  to  a  con- 
sideration of  the  special  forces  of  demand  and  supply, 
such  as  utihty  and  cost  of  production,  acting  upon  such 
goods.  In  studying  the  laws  of  money  we  need  to  attend 
not  so  much  to  the  conditions  determining  the  value  of 
one  kind  of  goods  in  relation  to  some  other  kind  or  kinds, 
as  to  the  conditions  determining  the  average  value  of 
goods  in  relation  to  money,  and  vice  versa.  We  have  to 
consider,  that  is,  the  general  level  of  prices,  and  conversely 
the  purchasing  power  of  money. 

This  relation  between  money  and  other  goods  has  sev- 
eral times  been  given  a  mathematical  form  of  statement.^ 
Let  S  represent  the  total  amount  of  money  (number  of 
dollars)  spent  in  a  given  community  during  a  given 
period  of  time,  say  a  year.  Let  M  represent  the  (average) 
number  of  dollars  in  that  community  during  the  same 
period.  Then  the  average  number  of  times  a  dollar  is 
spent  during  the  year  will  be  S/M.  This  is  the  velocity 
of  circulation  of  money  and  may  be  called  V. 
S  =  MS/M,  and  therefore,  by  the  method  of  substi- 
tution, S  =  MV.  In  words,  the  total  dollars  spent  for 
goods  is  equal  to  the  number  of  dollars  in  the  community 
times  the  average  velocity  of  circulation  of  those  dollars. 

But  the  total  number  of  dollars  spent  for  goods  is  also 

*  For  instance,  Newcomb,  Principles  of  Political  Economy,  New  York  (Har- 
p)er),  1885,  p.  346;  Edgeworth,  "Report  on  Monetary  Standard,"  Report  of  the 
British  Association  for  the  Advancement  of  Science,  1887,  p.  293;  Hadley, 
Economics,  New  York  (Putnam),  1906,  p.  197. 


4    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

equal  to  the  sum  of  the  quantities  of  all  the  kinds  of 
goods  bought,  times  their  respective  prices.  Let  the 
price  per  pound  and  the  number  of  pounds  of  sugar 
bought  be  represented  respectively  by  p  and  q,  the  price 
per  bushel  of  wheat  and  the  number  of  bushels  bought 
by  p^  and  q' ,  and  so  on.  Then  the  total  number  of 
dollars  spent  for  goods,  i.e.  S,  is  equal  to  pq  +  p'q^  +  etc. 
Since  two  things  equal  to  the  same  thing  are  equal  to 
each  other,  and  since 

S  =  MV  and  also 
S  =  pq  +  p'q'  +  etc., 


therefore 


MV  =  pq  +  p'q'  +  etc. 


This  is  the  mathematical  statement  of  the  so-called 
quantity  theory  of  money,  omitting,  however,  any 
reference  to  credit  currency.^  It  asserts  simply  that  the 
quantity  of  money  times  its  velocity  of  circulation,  equals 
the  prices  of  goods  bought  with  money,  times  the  quan- 
tities bought.  The  conclusion  follows,  therefore,  that 
if  the  quantity  of  money,  M,  increases,  while  the  velocity 
of  circulation  and  the  volume  of  trade  remain  the  same, 
prices  will  rise  in  the  same  proportion.  A  decrease  in 
the  amount  of  M  would,  on  the  same  assumption,  be 
accompanied  or  followed  by  a  fall  in  the  money  prices 
of  goods.  An  increase  in  the  g's  ^  or  volume  of  trade 
would,  other  things  equal,  occasion  a  fall  of  prices ;  and  a 
decrease  in  the  g's,  a  rise  of  prices. 

1  For  consideration  of  credit,  see  Chs.  II  and  III  (of  Part  I), 
'The  g's  or  quantities  of  goods  should  be  held  to  include  not  only  finished 
goods  exchanged  in  trade  and  goods  purchased  for  raw  material,  but  also  the 
additions  made  by  labor  to  the  utility  of  goods  and  paid  for  in  wages  and  the 
additions  made  by  the  service  of  "waiting"  and  paid  for  by  means  of  interest, 
dividends,  etc. 


LAWS  OF  MONEY  S 

Causal  Explanation  of  the  Price  oj  a  Given  Kind  of  Goods 

A  quantitative  or  mathematical  statement  of  a  prin- 
ciple is  not,  however,  an  adequate  explanation  of  that 
principle.  In  this  case,  the  explanation  must  be  found 
in  the  working  of  the  market,  in  competition  with  each 
other  of  buyers  and  of  sellers.  This  means  that  there 
must  be  an  analysis  of  the  forces  of  supply  and  demand  in 
relation  to  general  or  average  prices,  in  addition  to  the 
usual  study  of  those  forces  in  relation  to  particular 
prices. 

The  price  of  any  particular  kind  of  goods,  say  the 
price  of  wheat  per  bushel,  is  commonly  said  to  be  fixed 
by  the  equation  of  supply  and  demand.  But  these 
terms  are  frequently  misunderstood.  For  example, 
supply  is  sometimes  thought  of  as  the  total  stock. 
Demand  is  thought  of  as  the  amount  wanted  by  pur- 
chasers, but  without  much  reference  to  the  exact  condi- 
tions determining  this  amount.  As  a  matter  of  fact, 
supply  is  not  the  total  stock  of  a  good,  whatever  relation 
it  may  have  to  this  stock.  Supply  is  different  according 
as  price  is  different.  Hence  any  reference  to  supply 
should  specify  a  price^  The  supply  of  any  good  at  a 
given  price  is  the  amount  which  sellers  are  ready  to 
dispose  of  at  that  price.^  Thus,  the  supply  of  wheat 
at  a  price  of  $i.io  per  bushel  may  be,  in  a  given  market, 
1 ,000,000  bushels.  That  is,  at  a  price  of  $1 .  10  per  bushel, 
there  are  so  many  persons  ready  to  sell  wheat  and  ready 
to  sell  such  quantities,  that  1,000,000  bushels  may  be  had. 

1  See  J.  S.  Mill,  Principles  of  Political  Economy,  Book  III,  Ch.  II,  §  4. 
One  of  the  best  recent  presentations  of  the  theory  of  supply  and  demand  is  to 
be  found  in  Fisher,  Elementary  Principles  of  Economics,  New  York  (Macmillan), 
1912,  Ch.  XV. 


6    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

In  general,  the  higher  the  price,  the  larger,  other  things 
equal,  will  be  the  supply ;  and,  similarly,  the  lower  the 
price,  the  smaller  will  be  the  supply.  If  the  price  of  any 
good  is  lower  relatively  to  other  desired  goods,  producers 
and  sellers  will  be  less  incKned  to  bring  the  good  to  market 
for  disposal,  and  may  even  turn  their  attention  to  other 
lines.  If  the  price  is  higher,  they  will  be  more  inclined 
to  sell  large  quantities,  and  some  may  be  tempted  to 
forsake  other  lines  to  produce  the  good  in  question. 

In  the  same  way,  reference  to  demand  should  specify 
a  price.  Analogously,  the  demand  for  any  good  at  a 
given  price  is  the  amount  that  purchasers  stand  ready  to 
take  at  that  price.  If  at  $i.io  per  bushel  the  demand  for 
wheat  is  for  1,000,000  bushels,  then  the  number  of  per- 
sons wishing  to  buy  wheat  is  such,  and  the  amounts  they 
individually  stand  ready  to  buy  are  such,  as  to  make 
an  aggregate  of  1,000,000  bushels.  Other  things  equal, 
demand  rises  as  price  falls,  and  falls  as  price  rises.  The 
lower  the  price  of  any  good  in  relation  to  prices  of  other 
goods,  the  more  ready  are  purchasers  to  buy  it ;  and  the 
higher  the  price,  the  less  ready.  The  price  of  any  good, 
whether  of  cotton,  labor  services,  bills  of  exchange  or 
anything  else  marketable,  is  fixed  where  supply  and 
demand  are  equal. 

It  is  not,  however,  an  explanation  of  price  merely  to 
state  that  it  is  fixed  where  supply  and  demand  are  equal. 
It  is  necessary  further  to  inquire  why  price  is  fixed  at  that 
point.  If  supply  of  and  demand  for  wheat  in  a  given 
market  are  equalized  at  $1.10  per  bushel,  why  may  not 
the  price  nevertheless  be  $1  ?  If  we  assume  $1  to  be  the 
price,  we  see  that  such  a  price  represents  a  position  of 
unstable  equilibrium.  At  this  price,  the  demand  would 
be  in  excess  of  the  supply.    The  persons  anxious  to  buy 


LAWS  OF  MONEY  7 

wheat  are  ready  to  buy,  at  this  price,  more  than  can  be 
had,  and  since  even  at  $1.10  the  amounts  they  will  buy 
are  equal  to  the  amounts  they  can  get,  it  appears  that 
there  are  many  who  would  gladly  pay  more  than  $1  per 
bushel  rather  than  go  without  wheat  entirely.  Here, 
then,  are  persons,  many  of  whom  would  pay  more  rather 
than  not  get  the  wheat,  the  aggregate  of  whose  desired 
purchases  at  $1  per  bushel  must  exceed  the  total  supply 
offered.  If  $1  is  the  price,  some  who  would  gladly  pay 
that  and  more  cannot  get  the  wheat  they  desire.^  Each 
intending  purchaser  will  fear  that  he  will  be  one  of  those 
who  fail  to  get  what  they  wish.  Since  all  cannot  be 
satisfied  and  since  he  himself  may  not  be,  he  is  likely  to 
offer  more  than  $1  in  the  hope  that  sellers  will  be  per- 
suaded to  sell  to  him,  at  least.  But  he  is  not  likely  to 
offer  more  than  $1.10.  According  to  our  hypothesis, 
a  price  of  $1.10  will  bring  forth  a  supply  fully  equal  to 
the  demand.  Even  if  other  buyers  are  foolish  enough  to 
offer  a  higher  price  and  are  sold  to  in  preference,  yet  since 
the  demand  of  these  others  would  not  absorb  the  entire 
supply,  a  purchaser  who  offered  $1.10  would  secure  the 
wheat  desired. 

As  the  price  is  kept  from  going  below  that  height  which 
equahzes  supply  and  demand,  by  the  competition  of 
buyers,  so,  by  the  competition  of  sellers,  it  is  kept  from 
going  above  that  height.  If  $1.10  a  bushel  is  the  equal- 
izing price,  the  competition  of  sellers  will  prevent  the 
price  from  being  higher,  say  $1.15.  For  at  $1.15  there 
would  presumably  be  a  smaller  demand  and  a  greater 
supply.  That  is,  at  $1.15  there  would  be  sellers  anxious 
to  dispose  of,  in  the  aggregate,  more  wheat  than  buyers 

^  This  explanation  of  the  nature  of  competition  is  well  set  forth  in  Hadley, 
Economics,  pp.  75-77. 


8    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

would  take.  Some  of  these  prospective  sellers  must  be 
doomed  to  disappointment,  and  those  most  anxious  to 
sell  would  therefore  bid  against  each  other  in  lowering  the 
price  to  the  point  where  supply  and  demand  were  equal. 
This  they  would  do  because  in  no  other  way  could  they 
be  sure  of  selling  their  wheat.  But  they  need  not  go 
below  the  equalizing  price,  because  when  that  price  is 
reached  there  are  enough  more  buyers  or  enough  fewer 
sellers,  or  both,  to  insure  sales  by  those  still  in  the  market 
and  desiring  to  sell.  Even  if  some  should  offer,  unwisely, 
to  sell  at  a  lower  price,  yet  since  these  could  not,  by  our 
hypothesis,  satisfy  the  demand,  all  who  charged  the 
equahzing  price  would  still  find  purchasers.  The  market 
price  of  any  kind  of  goods,  therefore,  tends  to  be  that 
price  which  equalizes  supply  and  demand,  and  is  pre- 
vented by  the  forces  of  competition  from  going  above  or 
below  it. 

§3 

Causal  Explanation  o]  the  General  Level  of  Prices 

Let  us  now  apply  the  principles  of  supply  and  demand 
to  the  general  level  of  prices.  We  shall  see  that  much  the 
same  kinds  of  competitive  forces  which  fix  any  one  price 
(as  above  explained)  in  relation  to  other  prices,  fix  the 
general  level  of  prices  of  goods  in  terms  of  money.  We 
shall  consider,  first,  the  supply  of  goods,  including  the 
services  of  labor  and  of  "waiting"  {i.e.  investing,  or 
putting  capital  into  use,  the  service  for  which  interest  is 
paid)  offered  for  money,  and  the  demand  for  goods  by 
those  having  money  to  spend.  Afterwards  we  can  reverse 
our  method  and  consider  the  supply  of  and  the  demand 
for  money  in  exchange  for  other  goods. 

Where  there  is  only  fiat  (inconvertible  paper)  money, 


LAWS  OF  MONEY  g 

the  supply  of  goods  in  general,  offered  for  money,  at  any 
level  of  average  prices  of  those  goods,  would  be  just  the 
same  as  at  any  other  level  of  prices.  This  is  very  nearly 
true  no  matter  what  the  money  system.^  If  wheat  prices 
are  higher  than  corn  prices,  or  vice  versa,  productive 
effort  may  be  diverted  from  one  line  into  another.  But 
we  are  now  not  discussing  changes  in  individual  or  rela- 
tive prices.  We  are  discussing  only  changes  in  the 
general  level  of  prices,  the  average  of  prices.  If  the  gen- 
eral level  of  prices  should  double,  there  is  no  reason  to 
believe  that  the  amount  of  goods  produced  for  sale  would 
on  that  account  greatly  increase.  Supposing  a  com- 
munity to  be  in  reasonable  prosperity  and  business 
activity  at  the  lower  prices,  an  increase  of  these  prices 
would  not  make  possible  a  very  greatly  increased  pro- 
duction. It  would  not  enable  men  to  work  longer  hours 
nor  would  it  make  machinery  more  efficient.  Neither 
would  it  stimulate  the  sales  of  goods  by  making  such  sales 
more  profitable,  since  a  general  rise  of  prices  simply 
means  that  money  has  a  less  value.  If  everything  should 
sell  for  twice  as  much  money  as  before,  the  sellers  would 
gain  nothing,  for  the  things  they  desired  to  buy  would 
also  cost  twice  as  much.  Looking  at  the  matter  from 
any  reasonable  point  of  view,  it  must  be  admitted  that 
the  supply  of  goods  in  general,  at  a  higher  level  of  prices, 
would  be  no  greater  (or  but  slightly  greater)  ^  than  at  a 
lower  level.  Likewise,  at  a  lower  level  of  prices,  the 
supply  of  goods  would  be  no  less  than  at  a  higher  one. 
A  lower  level  of  prices  would  not  mean  less  activity  or  a 
smaller  sale  of  goods.  It  would  pay  as  well  to  sell  goods 
at  a  low  level  of  prices  as  at  a  high  level,  since  at  the  lower 

1  See  remainder  of  this  section  for  explanation  of  why  it  is  not  always  entirely 
true. 

2  See  next  paragraph. 


lo    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

level  the  money  received  would  have  correspondingly 
greater  purchasing  power. 

The  lower  level  of  prices  would  only  decrease  the 
supply  of  other  goods  and  the  higher  level  increase  it,  in 
one  contingency,  and  then  only  to  a  very  limited  degree. 
When  the  currency  system  is  based  on  a  precious  metal, 
e.g.  gold,  a  lower  level  of  prices  means  a  higher  value 
of  gold  as  money.  It  might  therefore  divert  some  labor 
from  the  production  of  other  goods  to  the  production  of 
gold  for  coinage.  A  higher  level  of  prices  might  tend, 
in  the  same  degree,  to  divert  labor  from  gold  production 
towards  the  production  of  other  goods.  To  this  extent 
only,  a  higher  level  of  prices  would  tend  to  increase  the 
supply  of  goods  in  general  other  than  money,  and  a  lower 
ievel  of  prices  to  decrease  it. 

On  the  other  hand,  a  higher  level  of  prices  of  goods 
would  tend  to  decrease  the  demand  for  goods  by  persons 
having  money  to  spend.  For  with  higher  prices,  and  no 
greater  amount  of  money  to  spend,  buyers  of  goods  would 
be  unable  to  purchase  as  much  as  at  lower  prices.  Lower 
prices  of  goods  would  mean  that  the  money  of  purchasers 
would  go  farther. 

Let  us  now  suppose  a  doubling  of  the  amount  of  money. 
Prices  would  tend  to  increase  in  nearly  the  same  pro- 
portion. Suppose  prices  did  not  rise.  Then  purchasers 
of  goods  would  buy  all  they  were  in  the  habit  of  buying 
and  still  have  as  much  money  left  to  spend  as  they 
formerly  spent  all  together.  This  they  would  endeavor 
to  spend  at  once.  For  in  modern  countries  money  is  not 
hoarded  away,  but  only  enough  is  kept  on  hand  for 
emergency  requirements,  and  the  rest  is  spent.  Those 
who  save  are  spending  just  as  effectually  as  any  others. 
The  difference  is  in  what  they  buy.     Those  who  savq 


LAWS  OF  MONEY  ii 

buy  factories,  warehouses,  railroads,  farms,  etc.  Even 
though  their  savings  are  put  into  a  savings  bank,  they  are 
none  the  less  spent  for  investment  goods.  It  follows 
that  a  sudden  doubling  of  the  amount  of  money,  if  prices 
did  not  increase,  would  mean  a  demand  for  goods  far 
exceeding  the  supply.  The  amount  of  land  is  practically 
constant.  Doubling  the  amount  of  money  would  not 
enable  people  to  work  longer  hours  and  so  increase  the 
products  of  labor.  In  a  busy  community  the  supply  of 
goods  to  be  sold  simply  could  not  be  doubled  except 
with  an  increase  of  population  or  invention.  The  in- 
creased money  would  therefore  mean  that  at  the  old 
prices  the  demand  for  goods  in  general  would  exceed  the 
supply.  Purchasers  would  bid  against  each  other. 
Prices  would  rise.  Equilibrium  would  only  be  reached, 
supply  and  demand  be  equal,  at  a  general  level  of  prices 
nearly  (or,  if  fiat  money,  quite)  twice  that  which  had 
preceded. 

If  prices  rose  equally,  this  would  mean  a  doubling  in 
the  money  wages  of  labor  for  the  same  results  produced 
and,  similarly,  a  doubling  in  the  money  interest,  dividends 
or  profits  received  for  ''waiting."  Aside  from  disturb- 
ing effects  during  the  period  of  transition,  the  rate  of 
interest  would  be  the  same  with  the  high  prices  as  with 
the  low.  The  money  value  of  the  sum  waited  for  would 
be  doubled  and  the  money  value  of  the  interest  would  be 
doubled.  The  ratio  between  them  would  be  the  same 
as  before.  In  other  words,  since  prices  have  doubled, 
borrowers,  for  example,  would  require  twice  as  many 
dollars  as  before  and  would  also,  of  course,  pay  twice  as 
many  dollars  in  interest. 

In  the  light  of  the  principles  above  set  forth,  regarding 
supply  and  demand,  we  can  explain  why  the  excessive 


12     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

amounts  of  inconvertible  paper  money  sometimes  issued 
by  governments,  issued  particularly  in  time  of  war,  have 
resulted  in  very  exceptional  rises  in  the  price  level. 
This  increased  amount  of  money  means,  at  any  level  of 
prices,  a  greater  demand  for  goods.  Therefore,  that  the 
demand  for  goods  may  not  exceed  the  supply,  the  level 
of  prices  must  rise.  There  is  another  factor  of  impor- 
tance at  such  times,  viz.  public  confidence  in  the  money 
issued.  If  there  is  a  general  belief  that  the  money  will 
become  absolutely  valueless  or  greatly  decrease  in  value, 
then  many  who  have  goods  to  sell  will  refuse  to  sell  them 
for  this  money,  but  will  demand  gold  or  silver  or  other 
goods  in  exchange.  This  decrease  in  the  supply  of  goods, 
offered  for  money,  will  mean  that  only  a  higher  level  of 
prices  than  otherwise  would  result  can  equalize  supply 
and  demand.  Thus  is  to  be  explained  the  high  prices 
(and,  reciprocally,  the  great  depreciation  of  money)  in 
such  periods  as  the  American  Revolution,  the  Civil  War, 
etc. 

§4 

Causal  Explanation  of  the  Value  or  Purchasing  Power  of 
Money,  the  Reciprocal  of  the  Level  of  Prices  of  Goods 

Let  us  look  at  the  same  problem,  the  general  level  of 
prices,  from  the  other  side,  that  of  the  purchasing  power 
of  money  or  the  value  of  money  in  terms  of  goods.  We 
shall  consider  now  the  supply  of  money  offered  by 
purchasers  of  goods  (corresponding  to  demand  for  goods) 
and  the  demand  for  money  coming  from  sellers  of  goods 
(corresponding  to  the  supply  of  these  goods). 

Before  defining  supply  of  and  demand  for  money,  we 
must  select  a  phrase  to  express  the  price  of  money.  The 
value  or  price  of  money  is  usually  expressed,  not  in  terms 


LAWS  OF  MONEY  13 

of  any  one  thing,  but  in  terms  of  all,  or  most  other, 
purchasable  goods.  Its  value  or  its  price  is  measured  in 
the  amount  of  other  goods  it  can  buy.  The  value  or 
price  of  money  we  shall  therefore  call  the  purchasing 
power  of  money. 

We  may  now  define  money  supply  and  demand  con- 
sistently with  wheat  or  coal  supply  and  demand.  First, 
as  to  supply,  we  may  say  that  the  supply  of  money  at  any 
given  purchasing  power  is  the  amount  of  money  which 
would  he  supplied  —  i.e.  would  be  offered  in  purchase  of 
goods  —  at  that  purchasing  power.  Just  as,  at  a  higher 
price  of  wheat,  the  supply  in  the  long  run  would  tend  to 
be  greater  than  at  a  lower  price,  so,  at  a  higher  purchas- 
ing power  of  money,  the  supply  of  money  would  tend  to 
be  greater  than  at  a  lower  purchasing  power.  The  supply 
would  be  greater  at  a  higher  purchasing  power,  because, 
at  a  higher  purchasing  power,  it  would  be  worth  while  to 
turn  bullion  into  coins  or  even  to  mine  more  gold  for  that 
purpose.  The  supply  of  fiat  money  (irredeemable 
paper)  would  not  be  greater,  but  would  be  just  the  same 
at  a  higher  purchasing  power  as  at  a  lower.  The  normal 
supply  of  money  at  any  purchasing  power  and  during 
any  period  of  time,  the  amount  that  would  be  offered  by 
sellers  of  money  {i.e.  buyers  of  goods)  involves,  as  Walker 
has  pointed  out,^  the  quantity  of  money  and  its  rapidity 
or  velocity  of  circulation.  This  velocity  of  circulation 
may  be  less  than  unity ;  that  is,  most  of  the  money  may 
circulate  less  than  once  if  we  are  deahng  with  an  instant 
or  a  short  period  of  time.  But  if  we  are  dealing  with  a 
long  period  of  time,  say  a  year,  and  with  the  conditions 
determining  normal  purchasing  power,  the  velocity  will 

1  Political  Economy,  Advanced  Course,  third  edition,  New  York  (Holt)  1887, 
p.  129. 


14    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

perhaps  be  20  or  more.^  In  any  case,  the  supply,  the 
amount  that  would  be  offered  at  any  given  purchasing 
power,  is  the  total  amount  which,  at  that  purchasing 
power,  would  be  on  hand,  multiplied  by  its  velocity; 
and  it  may  be  represented,  therefore,  as  MV. 

Turning  to  the  subject  of  demand,  we  may  properly 
define  the  demand  for  money,  at  any  purchasing  power, 
as  the  amount  of  money  that  would  be  taken  by  sellers 
of  goods,  at  that  purchasing  power.  The  demand  for 
money  comes  from  the  sellers  of  other  goods  who  wish 
to  take  money  in  exchange  for  those  goods.  They  may  be 
said  to  buy  money  with  the  goods  they  sell.  When  the 
money  is  altogether  fiat  (inconvertible  paper)  money, 
the  amount  of  goods  offered  for  money  will  not  be  affected 
by  the  purchasing  power  of  money.  With  an  exception 
shortly  to  be  noted,  this  is  also  true  in  the  case  of  such  a 
commodity  money  as  gold  or  silver.  That  the  purchas- 
ing power  is  at  any  time  greater  or  less,  provided  only  it  is 
not  fluctuating,  affects  neither  for  good  nor  ill  the  sellers 
of  goods.  If  the  purchasing  power  of  money  is  greater, 
they  will  still  sell  their  goods  as  readily  for  money  since 
the  smaller  amount  of  money  so  received  will  go  as  far 
as  would  a  larger  amount  having  a  smaller  purchasing 
power  per  unit  {e.g.  per  dollar).  But  their  demand  for 
money,  in  the  proper  use  of  the  term  ''demand,"  will 
not  be  the  same.  If  the  purchasing  power  of  money  is 
doubled,  demand  for  money  will  be  exactly  halved.  If 
the  purchasing  power  of  money  is  halved,  demand  for 
money  will  be  doubled.  Sellers  of  goods  will  take  all  the 
money  which  the  goods  they  desire  to  sell  will  bring. 
If,  therefore,  the  purchasing  power  of  money  is  halved, 

1  See  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  191 1, 
p.  290. 


LAWS  OF  MONEY  15 

i.e.  if  it  takes  twice  the  former  amount  of  money  to  buy 
the  same  goods,  then  the  demand  for  money,  the  amount 
sellers  of  goods  (buyers  of  money)  will  take,  at  this  pur- 
chasing power,  will  be  exactly  doubled.^ 

The  exception  to  be  noted  has  already  been  referred 
to  in  the  discussion  of  the  general  level  of  prices.^  It  oc- 
curs when  money  is  based  on  some  standard  commodity, 
as  gold,  having  an  appreciable  cost  of  production.  To 
double  the  purchasing  power  of  money  would,  in  fact, 
probably  reduce  the  demand  for  it  to  something  very 
slightly  less  than  half  what  it  had  been,  for  a  small  (rela- 
tively a  very  small)  amount  of  labor  would  probably  be 
diverted  from  the  production  of  other  goods  to  the  mining 
of  gold.  Therefore,  unless  the  value  of  money  more  than 
doubled  {i.e.  unless  money  prices  of  goods  became  less  than 
half),  the  money  which  would  be  taken  by  sellers  of  the 
somewhat  smaller  stock  of  goods  would  be  less  than  half 
as  great.  Similarly,  a  fall  of  half  in  the  value  of  money 
would  very  probably  divert  some  labor  from  gold  mining 
into  other  lines,  and  so  might  slightly  more  than  double 
the  demand  for  money.  For  every  one  would  be  ready 
to  sell  his  goods  at  twice  the  former  price,  and  there  would 
be  more  goods  to  sell.  Normal  demand,  therefore,  for 
money,  i.e.  long-run  demand,  cannot  be  distinguished  by 
any  exact  proportion  from  demand  for  other  goods. 
But  when  the  money  does  not  involve  an  appreciable  cost 
of  production,  but  is  inconvertible  paper,  or,  for  any 
money,  where  an  extremely  short  period  is  involved,  the 
demand  for  money  varies  inversely  with  its  purchasing 
power. 

1  Were  it  not  for  the  exception  next  to  be  mentioned,  the  demand  curve  for 
money  would  be  always  a  rectangular  hyperbola. 
*  §  3  of  this  chapter  (I  of  Part  I). 


i6    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  demand  for  money  by  sellers  of  goods  may  be  said 
to  be  the  money  value  at  which  they  would  sell  those 
goods ;  therefore,  the  prices  times  the  quantities ;  there- 
fore, pq  +  p'q  +  etc.  The  purchasing  power  of  money 
is  fixed  where  supply  is  equal  to  demand,  where 
MV  =  pq  -\-  p'q'  +  etc.  The  equation  of  exchange  may 
be  regarded  as  simply  a  mathematical  mode  of  stating 
that  the  p^s,  the  purchasing  power  of  money,  must  be 
such  that  supply  of  money  equals  demand,  i.e.  that 
MV  =  pq  +  p'q'  +  etc. 

§  5 
The  Theory  oj  Bimetallism 

The  laws  of  supply  and  demand  serve  to  explain  the 
effects  of  the  various  monetary  systems  which  have  been 
tried  in  different  countries.  Important  among  those 
monetary  systems  is  bimetalHsm.  BimetalHsm  involves 
the  concurrent  circulation  of  two  metals  at  a  fixed  legal 
ratio.  Both  metals  are  coined  by  government,  for  those 
bringing  the  metals  to  the  mints,  in  any  desired  quantity, 
and  coined  without  charge  or  for  the  mere  cost  to  gov- 
ernment of  coining.  Both  metals,  when  so  coined,  are 
legal  tender  for  the  payment  of  debts  and  taxes,  at  the 
value  ratio  fixed.  Thus,  bimetallism  at  i6  to  i  meant, 
for  the  United  States,  that  the  amount  of  silver  in  the 
silver  dollar  should  be  approximately  i6  times  the  amount 
of  gold  in  a  gold  dollar,  that  gold  and  silver  should  both 
be  coined  freely  and  without  Kmit,  and  that  a  debtor 
should  be  able  to  Liquidate  the  same  debt  with  loo  silver 
dollars  as  with  loo  gold  dollars. 

Bimetallism  may  succeed  if  the  legal  ratio  is  not  too  far 
from  the  market  ratio  of  values  existing  when  the  system 


LAWS  OF  MONEY  17 

is  started.  If  the  amount  of  silver  in  the  legal  silver  dollar 
is  worth  98  per  cent  as  much  as  the  gold  in  the  gold  dollar, 
or  98  cents,  then  the  system  may  succeed.^  It  will 
succeed  because  the  possibihty  of  using  98  cents'  worth  of 
silver,  if  coined,  to  pay  a  $1  debt  (or  tax)  previously 
payable  in  gold,^  will  stimulate  the  coinage  of  silver. 
This  extra  demand  for  silver  will  increase  its  value. 
Otherwise  expressing  the  matter,  we  may  say  that  the 
withdrawal  of  silver  from  the  arts,  tending  to  cause  a  de- 
creased supply  of  silver  for  arts  uses,  will  increase  its  valu6. 
The  greater  quantity  of  money  will  tend  to  make  some- 
what higher  prices  and  a  somewhat  lower  value  of  a  dollar 
(whether  gold  or  silver) .  This  may  discourage  the  coin- 
age of  gold  or  even  cause  the  melting  of  some  gold  coin 
into  bullion.  We  may  say  that  the  less  demand  for  gold 
has  made  its  value  fall,  or  that  the  melting  of  gold  coin 
and  the  consequent  greater  supply  of  gold  in  the  arts  has 
made  its  value  fall.  The  sequence  is,  then,  flow  of  silver 
from  bullion  into  coin,  slightly  depressed  value  of  coin, 
flow  of  gold  from  coin  into  bullion.  Silver  has  risen  in 
value.  Gold  has  fallen.  Probably  the  silver  dollar  is, 
therefore,  now  worth  the  same  as  the  gold  dollar  instead 
of  98  per  cent  as  much.  If  the  bullion  content  of  the  gold 
dollar  came  to  be  of  the  less  value,  debtors  would  prefer 
to  coin  gold  and  the  flow  would  be  in  the  opposite  direc- 
tion, but  likewise  towards  the  estabHshment  of  equiHb- 
rium. 

Suppose,  however,  that  the  amount  of  silver  in  a  silver 
dollar  is  worth  only  40  per  cent  of  the  gold  dollar  (which 
was  more  nearly  the  case  with  the  silver  dollar  when  its 

1  Cf.  Fisher,  Elementary  Principles  of  Economics,  pp.  230,  231. 

2  Or  money,  on  a  parity  with  the  gold,  other  than  silver  money  coined  for 
account  of  the  debtor. 

C 


i8    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

free  coinage  was  advocated  in  1896).  Then  the  danger 
would  be  that,  long  before  the  increased  demand  for  silver 
as  money  and  its  decreased  supply  in  the  arts,  coupled 
with  the  decreased  demand  for  gold  as  money  and  its 
increased  supply  in  the  arts,  had  brought  about  the 
desired  equilibrium  of  value,  the  gold  would  be  entirely 
driven  out  and  the  money  used  would  simply  be  silver 
instead  of  gold.  The  whole  question  would  be  whether 
the  scarcity  of  silver  in  the  arts  and  the  plentifulness  of 
gold  in  the  arts  would  be  sufficiently  marked  to  make 
the  relative  values  the  same  as  in  the  legal  ratio,  before 
silver  enough  had  been  taken  from  the  arts  uses  to  fill 
all  the  money  circulation;  and  then,  whether  sufficient 
additional  suppHes  of  silver  could  be  got  from  the  mines 
to  drive  out  the  gold  without  forcing  the  margin  of  pro- 
duction unprofitably  low,  i.e.  without  mining,  at  a  loss, 
from  poor  mines. 

For  one  country  alone,  the  prospects  of  success  in  es- 
tabHshing  bimetalHsm  would  be  much  less  bright  than 
for  a  group  of  important  commercial  countries.  For  if 
one  country  tried  it  alone,  endeavoring  by  free  coinage 
to  make  40  cents'  worth  of  silver  equal  to  $1  worth  of 
gold,  it  would  have  to  absorb  into  its  currency,  not  only 
silver  from  within  its  own  borders,  but  silver  flowing  to 
it  from  all  the  world,  and  its  own  demand  in  relation  to 
such  a  great  supply  might  increase  the  value  of  silver 
relatively  Httle.  And,  as  the  silver  drove  out  the  gold, 
the  latter  would  not  fall  rapidly  in  value  through  con- 
gesting the  arts,  but  would  be  distributed  to  the  money 
supplies,  as  well  as  the  arts,  of  all  other  countries. 


LAWS  OF  MONEY  19 

§6 

The  Value  of  Subsidiary  Money 

At  the  present  time,  in  the  United  States,  France,  and 
elsewhere,  there  exists  the  so-called  limping  standard, 
i.e.  there  are  silver  coins  the  bullion  value  of  which  is  not 
equal  to  their  face  value,  but  the  amount  of  which  is 
strictly  limited.  In  the  United  States,  there  are  a  cer- 
tain number  of  silver  dollars  and  silver  certificates.  The 
silver  in  the  silver  dollars  is  worth  perhaps  about  half  of 
their  face  value.  But  they  cannot  drive  out  gold  because 
not  enough  are  coined  to  produce  such  a  result.  Any 
money,  even  paper,  if  put  forth  in  very  limited  quantities 
and  made  legal  tender  for  the  payment  of  debts  and  taxes, 
may  circulate  at  par  with  gold.  The  possibility  of  using 
it  for  debts  and  taxes  creates  a  demand  for  it,  and  others 
will  take  it  because  they  in  turn  can  pass  it  to  those  hav- 
ing such  uses  for  it.  A  general  public  confidence  in  and 
willingness  to  take  it  at  the  legal  value,  is  developed. 
On  the  other  hand,  the  limitation  of  its  quantity  means 
a  limited  supply.  The  demand  for  it  equals  this  supply, 
at  a  value  equal  to  par.  Where  a  limited  amount  of 
money  is  issued  by  coining  metal  of  less  value  than  the 
money,  or  by  printing  paper,  this  is  done  by  government 
exclusively  on  its  own  account.  Otherwise  there  would 
be  special  favor  shown,  at  the  general  expense,  to  those 
persons  for  yrhom  the  coining  was  done. 

Making  paper  or  other  money  redeemable  in  gold  is 
merely  a  way  of  making  the  forces  of  demand  and  supply 
automatic  in  keeping  up  the  value  of  such  credit  money .^ 
If  for  any  reason,  e.g.  overissue  or  lack  of  confidence,  the 
value  of  such  money  sinks  below  tjie  value  of  the  gold 

1  Cf.  Fisher,  The  Purchasing  Power  of  Money,  pp.  262-263. 


20     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

in  which  it  is  redeemable,  the  holders  of  the  paper  money 
at  once  present  it  in  large  quantities  for  redemption. 
This  immediately  decreases  the  supply  of  it,  and  thus 
automatically  prevents  its  entire  driving  out  of  gold. 
Prompt  redemption  at  the  same  time  gives  confidence 
and  so  maintains  a  demand  for  it.  But  the  limitation 
of  supply,  automatic  or  otherwise,  is  important,  for  no 
amount  of  confidence  can  prevent  a  fall  in  the  value  of 
money  which  increases  indefinitely  in  quantity.  An 
increase  in  gold  itself  tends  to  raise  prices  and  lower 
the  value  of  gold.  An  increase  of  paper  money  tends 
to  increase  prices  in  paper.  Redeemability  prevents 
prices  in  paper  from  ever  rising  higher  than  prices  in 
terms  of  gold. 

In  the  case  of  paper  money,  the  receiver  is  really  a 
creditor.  He  gets  a  credit  claim,  not  real  wealth.  The 
paper  money  evidences  a  right  based  on  its  general 
acceptability,  or  on  its  redeemabihty  by  government,  to 
an  amount  of  wealth  or  income  services  equal  to  the 
value  of  the  money.  The  issue  of  paper  money  is  a 
species  of  borrowing  by  government ;  but  no  interest  is 
paid,  because  the  holder,  unlike  the  holder  of  government 
bonds,  has,  if  the  money  is  generally  acceptable,  a  demand 
claim.  He  does  not  need,  therefore,  to  wait  for  his 
desired  goods  any  longer  than  he  wishes  to,  but  can  spend 
the  money  and  get  goods  at  any  time  from  another,  who 
can  do  hkewise  with  a  third,  etc.  He  does  not  need,  there- 
fore, to  be  in  the  position  of  a  creditor  longer  than  his 
own  convenience  dictates.  The  general  acceptabihty 
of  such  money,  if  it  is  generally  acceptable,  makes  the 
holder  willing  to  forego  any  other  interest.^ 

The  money  of  the  United  States  includes  gold  and  silver 

1  See  Cb.  II  (of  Part  I),  §§  3,  4- 


LAWS  OF  MONEY  21 

coins,  gold  certificates,  silver  certificates,  United  States 
notes  (greenbacks),  treasury  notes,  and  subsidiary  coins 
(quarters,  dimes,  etc.).  There  are  also  bank  notes,  but 
these  may  be  better  considered,  along  with  other  bank 
credit,  in  the  next  chapter.  All  the  paper  money  except 
silver  certificates  is  redeemable  by  law  in  gold.  Silver 
certificates  are  redeemable  in  silver.  No  law  expressly 
makes  the  silver  dollars  redeemable  in  gold ;  but  it  is 
the  duty  of  the  Secretary  of  the  Treasury  to  maintain  the 
parity  of  the  silver  coinage  with  gold,  and  in  practice  any 
kind  of  our  money  is  exchangeable  at  the  United  States 
Treasury  for  any  other  kind.  Even  without  this  prac- 
tice, the  Kmitation  on  the  number  of  silver  dollars  and 
their  full  legal  tender  quality  would  doubtless  maintain 
them  at  par  value,  although  the  value  of  the  contained 
bullion  is  much  less. 

§7 

The  Value  0}  Money  as  Related  to  the  Value  of  a  Standard 
Money  Metal 

Most  countries  have  now  the  gold  standard.  All 
money  is  redeemable  in  or  in  some  way  related  to  gold, 
and  the  value  of  money  tends  to  equal  the  value  of  the 
mint  equivalent  in  gold.  So  long  as  gold  is  coined  freely, 
and  in  any  quantity  desired,  into  money,  the  value  of 
gold  as  money  and  as  bullion  must  be  the  same.  For 
if  gold  coin  came  to  have  more  value  than  gold  bulKon 
to  be  used  in  the  arts,  then  persons  having  gold  bullion 
would  hasten  to  get  it  coined.  The  consequent  increase 
of  money  would  raise  the  prices  of  goods  and  lower  the 
value  of  money.  The  decrease  of  gold  for  use  in  the  arts 
would  increase  its  value  in  that  use.  Equal  value  in  the 
two  uses  must  soon  be  reached.     If,  on  the  other  hand, 


22     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

gold  as  money  should  have,  at  any  time,  a  less  value  than 
the  same  amount  of  gold  as  bulHon,  then  all  newly  mmed 
gold  would  be  used  in  the  arts  and  Httle  or  none  coined, 
until  gold  in  the  arts  was  so  plentiful  and  money  so  scarce 
as  to  make  the  values  even  again.  Gold  money,  if  full 
weight,  might  even  be  melted  into  bullion,  if  it  were 
worth  enough  more  in  the  latter  use  to  pay  for  the 
trouble. 

Eventually,  then,  since,  when  the  gold  standard  is  in 
force,  the  value  of  money  and  the  value  of  gold  bulHon 
tend  to  be  the  same,  both  depend  upon  the  amount  of 
gold  mined  relative  to  the  use  for  it.  The  cost  of  pro- 
duction of  gold,  and,  therefore,  the  number  and  richness 
of  gold  mines,  is  not  without  an  influence,  in  the  last 
analysis,  on  the  level  of  prices,  and  on  its  reciprocal, 
the  purchasing  power  of  money.^ 

§8 

The  Level  of  Prices  and  the  Value  of  Money  in  One 
Country  or  Locality  as  Related  to  the  Level  of  Prices 
and  the  Value  of  Money  in  Another 

Before  concluding  this  chapter,  something  should  be 
said  regarding  the  relation  of  the  quantity  of  money  and 
prices  in  one  locality  or  country  to  the  quantity  of  money 
and  prices  in  others.^  The  subsidiary  and  credit  money 
of  one  country  is  commonly  not  received  in  other  countries. 
Gold  or  silver  (at  present,  with  the  gold  standard  general, 
chiefly  gold)  is  passed  from  one  country  to  another  in 
payment  for  goods  or  services  or  to  redeem  obligations. 

» These  facts  are  mechanically  expressed  in  Fisher,  The  Purchasing  Power  oj 
Money,  pp.  96-11 1. 

'  For  a  fuller  statement  see  Fisher,  The  Purchasing  Power  of  Money,  pp.  90- 
96. 


LAWS  OF  MONEY  23 

Between  different  countries,  the  gold  passes  only  by- 
weight,  but  since  gold  coin  and  bulHon  are  related  in  all 
gold  standard  countries,  the  effect  of  the  flow  of  gold  from 
one  country  to  another  is  to  decrease,  relatively,  the 
quantity  of  money  in  the  one  and  to  increase  it,  rela- 
tively, in  the  other.  Between  parts  of  the  same  nation, 
all  legal  tender  money,  whether  gold,  silver,  or  paper, 
passes  freely. 

What  are  the  laws  of  this  flow?  Obviously,  money, 
like  all  things  else,  flows  to  those  places  where  it  has  the 
greatest  value,  where  it  can  buy  the  most  of  other  things. 
That  is,  money  flows  from  those  places  or  countries  where 
prices  of  goods  are  high,  to  those  places  or  countries 
where  prices  are  low.  Goods  are  bought  where  they  can 
be  bought  the  cheapest.  Money  goes  to  pay  for  the 
goods.  Hence,  money  flows  to  those  places  where  there 
are  low  prices.  But  low  prices  means  high  purchasing 
power  or  value  of  money.  Therefore  money  flows  to 
those  places  where  its  value  is  high.  When,  however, 
one  country  has  an  inconvertible  paper  money  unrelated 
to  the  money  of  another,  no  such  flow  can  take  place. 
When  paper  money  is  first  issued  in  one  country  it  tends, 
by  raising  prices,  to  cause  purchases  abroad,  where 
prices  have  not  thus  been  raised.  As  the  paper  money 
is  not  legal  tender  elsewhere,  gold  must  be  sent  to  pay 
for  the  goods  thus  bought.  The  continuing  issue  of 
paper  money  may  drive  all  the  gold  out  of  the  currency 
of  the  country  issuing  the  paper.  Until  it  does  so,  the 
effect  on  prices  appHes  to  other  countries  as  well;  the 
effect  is  distributed  over  all.  Though  the  paper  circu- 
lates only  in  the  issuing  country,  it  displaces  gold  and 
pushes  the  gold  into  other  countries.  But,  when  enough 
paper  money  has  been  issued   completely  to  drive  out 


24    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

gold,  no  such  further  effect  on  other  countries  can  be 
produced.  Trade  will  still  take  place. ^  Commodities  of 
one  sort  are  bought  and  commodities  of  another  sort 
are  sold.  Gold  itself  may  be  traded  back  and  forth.  But 
the  currency  of  the  one  country  is  absolutely  unrelated 
to  the  currencies  of  others. 

§9 

Summary 

In  this  chapter  we  have  been  concerned  chiefly  with 
the  laws  of  money,  an  important  part  of  the  mechanism 
of  civilized  commerce.  We  saw,  first,  that  the  general 
level  of  prices  of  goods  varies,  other  things  equal,  with 
the  quantity  of  money.  This  fact  was  mathematically 
expressed  in  the  so-called  *' equation  of  exchange," 
MV  =  pq  +  p'q'  +  etc. 

Analysis  of  the  causal  relations  between  quantity  of 
money  and  prices  led  us  to  demand  and  supply  and  the 
ordinary  forces  of  competition  as  an  explanation.  It 
was  seen  that  increased  money  involves  higher  prices  of 
goods  to  equalize  supply  of  and  demand  for  those  goods, 
and,  conversely,  a  lower  purchasing  power  or  value  of 
money,  to  equalize  supply  of  and  demand  for  that  money. 
Supply  of  money  might  be  determined  by  government  in 
the  case  of  inconvertible  paper  but  is  generally  a  matter 
of  the  production  of  the  precious  metals,  especially  gold. 
The  possibiUty  of  successful  bimetallism  was  shown  to 
depend  upon  the  ratio  chosen  and  the  relative  amounts  of 
money  of  each  metal  available  under  that  ratio.  Supply 
and  demand  acting  through  the  money  and  bulHon 
markets  tend  to  bring  market  ratio  to  equivalence  with 

» See  Ch.  VI  (of  Part  I),  §§  7,  8. 


LAWS  OF  MONEY  25 

legal  ratio,  but  may  not  have  the  effect  of  doing  this 
before  one  metal  is  driven  out  of  circulation.  The 
limping  standard  and  paper  money  were  shown  to  depend 
upon  limited  quantity  of  the  paper  money  or  the  over- 
valued (in  comparison  to  weight)  silver  (or  other  metallic) 
money,  and  upon  their  legal  tender  qualities.  The 
supply  is  limited ;  the  demand  kept  up.  Redeemability 
automatically  tends  to  prevent  oversupply  of  credit 
money  or  that  loss  of  confidence  which  decreases  demand 
for  the  money.  With  free  coinage  of  gold,  the  value  of 
gold  as  coin  and  as  bulKon  tends  to  be  the  same.  Finally, 
we  saw  that  the  flow  of  money  from  place  to  place  or 
country  to  country  is  a  flow  from  where  it  is  cheap  to 
where  it  is  dear,  from  where  it  buys  little  to  where  it  buys 
much,  from  where  prices  of  goods  are  high  to  where  they 
are  low. 


CHAPTER  II 
The  Nature  of  Bank  Credit 

§1 

How  and  When  Credit  Takes  the  Place  of  Money 

Credit  is  given  whenever  goods  are  sold  for  a  promise 
to  pay,  for  a  tacit  obligation  to  pay  later,  or  for  some 
form  of  claim  upon  a  third  party  such  as  a  bank.  The 
characteristic  of  all  credit  is  the  fact  that  the  person 
disposing  of  goods  to  another  does  not  immediately 
receive  payment  in  the  form  in  which  he  is  entitled, 
ultimately,  to  receive  it ;  but  receives,  instead,  a  right  to 
future  payment,  a  right  commonly  evidenced  by  some 
kind  of  commercial  paper.  Most  frequently  this  evidence 
is  the  check  on  a  bank,  showing  the  title  of  the  receiver 
or  payee  to  money  from  the  bank  on  demand ;  or  the  bill 
of  exchange,  showing  a  title  of  the  payee  to  money  from 
the  drawee,  sometimes  on  demand  and  sometimes  on  a 
definitely  agreed  date. 

The  term  "currency"  we  shall  use  generically  to  in- 
clude money,  which  is  generally  acceptable  in  exchange 
for  other  goods,  and  those  credit  rights,  less  generally 
acceptable,  which  are,  nevertheless,  largely  used  as  media 
of  exchange  and  therefore  serve  as  money  substitutes. 
Such  credit  instruments  as  checks,  bills  of  exchange,  and 
promissory  notes,  act  as  substitutes  for  money  only  if  the 
rights  to  the  sums  which  they  have  reference  to  are  trans- 
ferred to  third,  fourth  and  other  parties.     Only  in  such 

26 


THE  NATURE  OF  BANK  CREDIT      27 

cases,  therefore,  can  these  credit  instruments  or  the  rights 
which  they  certify  be  considered  as  currency.  If  a  prom- 
issory note  is  given  by  one  person  to  another  and  kept 
by  the  second  until  maturity,  the  use  of  the  note  merely 
means  that  money  is  paid  from  the  one  person  to  the 
other  at  a  later  date  instead  of  an  earlier.  There  is  no 
saving  of  the  use  of  money  in  the  sense  that  credit  takes  its 
place.  But  if  A  owes  B  $100  and  B  owes  C  the  same  sum, 
and  if  A's  promissory  note  to  B  is  used  by  the  latter  to 
pay  C,  then  the  use  of  money  is  to  some  extent  avoided. 
A  eventually  redeems  his  note  by  paying  C  the  money. 
Money  is  passed  once  instead  of  twice. 

The  ordinary  check,  sometimes  called  the  **  customer's 
check,"  is  similarly  used.  A  may  give  to  B  a  check  for 
$100.  B,  though  he  does  not  perhaps  use  the  same  check 
to  pay  C,  uses  the  same  demand  right  or  claim  on  the 
bank.  He  sends  in  the  first  check  and  has  it  credited  to 
his  account.  Then  he  gives  his  own  check  to  C.  C 
may  collect  from  the  bank  or  may  in  turn  pay  a  fourth 
party  by  check,  and  so  on.  In  practice,  the  sums  owed 
by  the  different  parties  will  probably  not  exactly  balance. 
B  may  pay  C  by  giving  the  latter  a  check  evidencing  the 
right  to  draw  the  sum  received  by  B  from  A  plus  other 
sums  received  by  B  from  D,  E,  F,  etc.  But  however 
this  may  be,  the  principle  is  the  same.  Thus,  the  bank 
deposit,  or  right  to  draw  from  a  bank,  takes  the  place  of 
money  in  effecting  exchanges  of  goods  or  services.  The 
use  of  bills  of  exchange  also  facilitates  the  balancing 
off  of  obligations  against  each  other,  without  the  payment 
of  coin.^ 

1  See  Ch.  Ill  (of  Part  I),  §  i. 


28    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

§2 
How  Commercial  Banking  is  Carried  On 

Credit  instruments,  or  credit  rights  —  for  the  paper  is 
in  each  case  but  evidence  of  the  underlying  obligation  — 
act  as  substitutes  for  money  primarily  through  the  inter- 
mediation of  commercial  banking/  and  foreign  exchange 
banking.  Commercial  banks  constitute  an  important 
part  of  the  mechanism  of  trade.  Their  work  facilitates 
internal  trade  and,  in  connection  with  the  work  of  foreign 
exchange  banks  and  brokers,  facihtates  external  trade 
as  well.  It  is  estimated  that  nine  tenths  of  the  total 
business  in  the  United  States  is  carried  on  through  the 
use  of  bank  credit.^ 

Bank  deposits  (rights  to  draw  from  a  bank  or  banks), 
which  circulate  by  means  of  checks,  may  come  into  being 
in  any  one  of  several  ways.  One  may  become  a  de- 
positor by  directly  depositing  money  (or  the  right  to  draw 
money,  received  by  check  from  some  one  else,  but  this 
merely  registers  a  transfer  of  a  deposit  and  does  not 
create  one) .  One  may  become  a  depositor  by  borrowing 
from  the  bank  in  which  the  deposit  is  to  be.  If  A  goes 
to  his  bank  and  leaves  there  $50,000  cash,  he  thereupon 
is  said  to  have  deposited  such  an  amount  in  the  bank 
and  can  draw  on  this  sum  at  will  by  issuing  checks  against 
it  in  favor  of  any  persons  to  whom  he  wishes  to  make 
payments.  But  A  may  also  go  to  the  same  bank,  give 
his  endorsed  note  or  other  satisfactory  security,  and  bor- 
row $50,000.  This  money  he  leaves  on  deposit.  The 
bank  is  then  said  to  lend  its  credit.     What  A  has  bor- 

1  Savings  banks  and  investment  banks  perform,  of  course,  important  functions, 
but  do  not  have  a  part  in  providing  a  substitute  for  money. 

2  See  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  igii, 
pp.  317,  318. 


THE  NATURE  OF  BANK  CREDIT      29 

rowed  is  not  money  but  the  right  to  draw  money  by  check, 
at  will.  The  bank  is  under  as  much  obligation  to  redeem 
his  checks  on  demand  as  if  he  had  directly  put  money 
into  the  bank.  On  the  other  hand,  A  is  under  obligation 
to  pay  the  bank,  when  his  note  matures,  the  amount 
borrowed  plus  interest. 

It  should  be  readily  apparent  that  a  bank  can,  in  ordi- 
nary times,  redeem  all  checks  presented  for  redemption, 
without  keeping  for  that  purpose  a  cash  reserve  which 
at  all  nearly  equals  its  liabilities.  The  total  value  of 
deposits  which  a  bank  is  under  obligation  to  pay  out  on 
demand,  may  be  $500,000.  Yet  it  is  certain  that  all  the 
depositors  will  not  call  for  their  money  at  the  same  time. 
Instead  of  drawing  it  out,  most  of  them  send  checks  back 
and  forth  to  and  from  others  who  do  likewise.  A  cash 
reserve  of  $100,000  may  be  ample.  Putting  the  matter 
in  the  opposite  way,  we  may  assert  that  if  there  is 
$100,000  in  cash  in  such  a  bank,  the  bank  can  lend  its 
credit,  i.e.  more  deposits  or  rights  to  draw,  to  the  extent 
of  (say)  $400,000. 

We  have  said  that  different  depositors  in  a  bank  liqui- 
date their  obhgations  to  each  other  by  giving  checks. 
There  is,  then,  simply  a  change  on  the  bank's  books. 
Any  amount  of  obhgations  can  be  thus  balanced.  Dif- 
ferent persons  are  made  successively  creditors  of  the  bank 
for  larger  or  smaller  sums.  The  situation  is  compKcated, 
but  the  principle  is  not  changed,  when  depositors  of  dif- 
ferent banks  have  business  deahngs  with  each  other. 
In  this  case,  which  is  a  decidedly  usual  one,  the  banks 
become  successively  each  other's  debtors  and  creditors 
and  have  to  settle  through  a  clearing  house.  Bank  A 
may  have  accepted  and  paid  cash  for,  or  credited  to 
depositors,  many  checks  on  Bank  B.     Bank  B  therefore 


30    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

owes  Bank  A.  Similarly,  Bank  C  may  owe  Bank  B,  etc. 
All  of  these  complicated  obligations  are  balanced  by  a 
clearing  house,  so  that  each  bank  pays  what  it  owes  net 
or  receives  what  is  owed  to  it  net,  and  a  great  deal  of  flow 
of  money  is  avoided.  In  other  words,  the  principle  of 
cancellation  is  appHed  whenever  possible  between  banks, 
just  as  it  is  in  any  one  bank  to  the  depositors  in  it. 

§3        ., 

Analysis  of  Relations  Involved  in  Commercial  Banking 

But  our  analy^  of  the  nature  of  commercial  banking 
is  not  complete  until  we  go  back  of  the  banks  and  examine 
the  relations  to  each  other,  through  the  banks,  of  those 
who  deal  with  the  banks  and  with  each  other.^ 

When  a  man  borrows  from  a  bank  (giving  proper  se- 
curity and  receiving  credit  on  the  bank's  books),  he  is 
getting  command  over  present  wealth  in  return  for  a 
promise  to  repay  wealth  in  the  future.  Those  who  pro- 
vide him  with  this  present  wealth  must  wait  before  being 
repaid.  Lending  always  involves  giving  up  something 
now  and  getting  something  in  the  future,  i.e.  lending 
always  involves  waiting.^  In  order,  then,  that  any  one 
may  borrow  from  a  bank,  some  person  or  persons  must  be 
the  lenders,  must  be  ready  to  give  up  goods  in  the  present 
for  goods  in  the  future,  must  provide  waiting.  The  bank 
itself  is,  for  the  most  part,  only  an  intermediary.  It 
brings  together  a  supply  of  waiting,  but  it  does  not,  to 
any  considerable  extent,  furnish  that  supply.     It  places 

*  The  argument  of  this  and  the  following  section  is  substantially  the  same  as 
that  presented  by  the  writer  in  the  Quarterly  Journal  of  Economics,  August,  1910, 
in  an  article  entitled  "Commercial  Banking  and  the  Rate  of  Interest." 

'  Though  there  may  also  be  waiting  where  there  is  no  lending  but  only  in- 
vesting. 


THE  NATURE  OF  BANK  CREDIT      31 

loanable  funds  at  the  disposal  of  borrowers,  but  it  is  not 
itself  the  ultimate  lender. 

The  persons  who  provide  the  waiting,  i.e.  who  are  the 
real  lenders,  may  be  divided  into  two  classes:  (a) 
those  who,  in  return  for  goods,  receive  checks  from 
borrowers  of  the  banks  (or  personal  notes  or  "ac- 
ceptances," which  the  banks  discount  0.  (b)  Those 
who  have  deposited  money  in  the  banks. 

Both  of  these  classes  have  claims  on  the  lending  banks, 
claims  which,  taken  all  together,  cannot  be  redeemed 
by  the  banks  except  as  those  who  have  borrowed,  those 
who  are  indebted  to  the  banks,  make  good  the  claims  of 
the  banks  on  them.  When  a  man  has  accepted  a  check 
from  one  who  has  borrowed  of  a  bank,  and  has  given 
goods  in  exchange  for  this  check,  he  has  actually  given 
present  wealth  in  exchange  for  a  mere  right  to  draw  on  the 
bank.  He  may,  therefore,  so  long  as  he  does  not  exercise 
this  right,  be  regarded  as  a  lender.  If  he  passes  a  check 
for  a  like  amount  to  another,  in  return  for  goods,  the 
other  becomes  the  lender,  since  this  other  now  has  the 
right  to  draw,  and  has  given  up  for  it  present  wealth. 
If,  instead  of  passing  a  check  to  another,  the  original 
payee  avails  himself  of  this  right  to  draw,  taking  money 
from  the  bank,  then  some  one  who  has  deposited  cash 
in  the  bank  vaults  may  be  looked  upon  as  the  lender, 
since  his  money  has  been  taken  from  the  bank  and  the 
borrower  is  expected  to  make  good  the  subtraction. 
Thus,  either  the  original  receiver  of  a  deposit  right  from 
a  borrower,  or  some  one  to  whom  he  passes  this  right,  or 
some  depositor  whose  cash  is  withdrawn  to  redeem  the 
check,  may  be  regarded  as  a  lender.  One  person  after 
another  holds,  for  a  time,  the  right  to  draw  money  from 

1  See  §  4  of  this  chapter  (II  of  Part  I). 


32    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

a  bank,  and  delays  using  that  right.  In  the  aggregate, 
there  is  a  very  great  deal  of  such  delaying  or  waiting  on 
the  part  of  persons  who  are  entitled  to  money  whenever 
they  desire  it,  but  who  do  not  find  it  convenient  to  claim 
it  at  once.  Each  of  them  knows  that  he  can  collect  from 
a  bank,  at  will,  or  can  pass  his  claim  to  another,  at  will, 
for  any  desired  goods.  Yet  commonly  there  is  an  interval 
during  which  such  a  person  remains  a  creditor  or  lender, 
preferring  the  convenience  of  an  available  bank  account 
to  the  immediate  possession  of  other  goods.  Commercial 
banking  has  as  a  function  to  combine  and  coordinate 
such  sporadic  potential  lending  or  sporadic  waiting,  so  as 
to  put  at  the  disposal  of  borrowers  a  sum  total  of  actual 
lending  which  is  fairly  constant  in  amount.  If  A  leaves 
his  claim  on  a  bank  untouched  for  one  week,  B  for  two 
weeks,  and  C  for  a  week  and  a  half,  because  convenience 
so  dictates,  why  may  not  D,  in  the  meanwhile,  be  using 
the  capital  which  they  do  not  yet  wish  to  use?  By 
bringing  all  these  parties  together,  commercial  banking 
enables  D  to  get  the  use  of  capital  without  at  all  incon- 
veniencing A,  B,  or  C.  Each  of  these  can  get  his  capital 
to  use  whenever  it  is  convenient,  but,  in  practice,  all  of 
them  will  not  want  it  at  the  same  time. 

It  may  be  objected  that  the  foregoing  treatment  is  too 
concrete  to  be  true.  In  any  individual  case  of  borrowing, 
it  is  perhaps  not  legitimate  to  pair  off  each  borrower  with 
one  or  more  ultimate  lenders,  assuming  that  a  particular 
holder  of  a  deposit  (or  two  or  three  such)  is  the  real  lender 
to  some  special  borrower.  Banks  bring  together  bor- 
rowers and  lenders  in  large  numbers,  and  there  is  no  log- 
ical way  to  assign  two  or  more  into  pairs  or  small  groups. 
But  it  cannot  be  denied  that  if  the  total  of  loans  is  taken, 
the  ultimate  lenders  are  the  total  number  of  acceptors  of 


THE  NATURE  OF  BANK  CREDIT      s^ 

checks  and  depositors  of  money,  both  of  which  classes  are 
depositors  in  the  broad  sense,  because  both  are  possessors 
of  the  right  to  draw.  Since  the  receivers  of  checks  are 
as  much  holders  of  rights  to  draw,  that  is,  of  deposits,  as 
are  the  cash  depositors,  we  may  say  that  all  the  borrowers 
are  in  debt  to  all  the  holders  of  deposits  and  that  the  latter 
are  lenders  to  the  former.  When  a  borrower  of  a  deposit 
has  not  transferred  it,  he  may  be  regarded  as  indebted 
to  himself,  since  his  right  to  draw  may  be  regarded  as  in 
the  main  backed  up  by  his  own  promise  to  pay.  The 
interrelations  of  banks  through  a  clearing  house  merely 
extend  these  relations  to  persons  depositing  in,  borrowing 
from,  and  receiving  checks  on,  other  banks.  The  prin- 
ciples are  the  same  as  in  the  case  of  a  single  bank. 

The  upshot  of  the  matter  is  that  modern  commercial 
banking  makes  it  possible  for  men  to  do  business  with 
each  other  by  becoming,  successively  and  alternately, 
through  the  banks  as  intermediaries,  each  other's  debtors 
and  creditors ;  while  yet  no  one  of  them  needs  to  remain 
a  creditor  or  lender  longer  than  suits  his  convenience. 

§4 

Why  Commercial  Banking  Commends  Itself  to  Business 
Men,  both  as  Lenders  and  Borrowers,  so  that  Com- 
mercial Bank  Credit  becomes  a  Substitute  for  Money 

Thus  bank  credit  acts  as  a  substitute  for  money.  Its 
use  is  simply  a  process  by  which  persons  become,  so  to 
speak,  successively  each  other's  creditors,  m  such  way  as 
ultimately  to  cancel  obligations  with  only  a  h'ttle  use  of 
cash.  But  we  have  yet  to  see,  fully,  just  why  bank 
credit  is  able  to  displace  money,  to  a  large  extent,  as  a 
medium  of  exchange.     It  does  this  by  conferring  an 


34    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

advantage  upon  both  borrowers  and  ultimate  lenders. 
Ultimate  lenders,  as  such,  are  benefited  by  the  conven- 
ience of  a  banking  service  for  which  they  do  not  have  to 
pay.  Borrowers  are  benefited  in  that  they  can  borrow 
on  better  terms  from  banks  than  would  otherwise  be 
possible. 

We  have  already  seen  that  commercial  banking  com- 
bines and  coordinates  waiting  which  would  in  any  case 
be  done.  Such  waiting  includes,  for  example,  the  wait- 
ing done  by  a  man  who  has  money  in  his  pocket  which  he 
intends  to  spend.  It  may  be  a  long  time  before  he  does 
spend  it,  but  he  knows  that  at  any  time  he  may  spend  it, 
and  when  it  is  convenient  he  will  do  so.  Practically 
everybody  finds  it  desirable  to  keep  part  of  his  assets 
in  ready  cash,  to  use  as  occasion  may  require.  The 
convenience  of  having  the  ready  cash  compensates  for 
the  loss  of  the  interest  that  might  be  received  from 
various  investments,  and  so  may  perhaps  be  regarded 
as,  itself,  a  kind  of  interest.  The  same  holds  true  of  bank 
deposits  subject  to  check  demand.  Business  firms  must 
keep  part  of  their  assets  in  such  form  as  to  be  able  to  meet 
current  expenses  and  occasional  emergencies.  They 
usually  keep  considerable  amounts  to  their  credit  in  some 
bank.  Even  in  the  absence  of  banks,  money  would 
have  to  be  kept  on  hand,  and  there  would  be  a  great  deal 
of  sporadic  waiting  remunerated  only  by  the  convenience 
of  having  cash  on  hand  when  wanted. 

The  lender,  therefore,  that  is,  for  example,  the  receiver 
of  a  check  on  a  bank,  who  becomes  a  depositor  and 
supplies  waiting,  is  not  injured  but  rather  is  benefited  by 
commercial  banking.  He  can  draw  upon  his  account  at 
will,  and  this  account  is  both  safer  and  more  convenient 
(especially  for  making  large  payments  and  payments  of 


it 


THE  NATURE  OF  BANK  CREDIT      35 

odd  sums)  than  the  equivalent  of  ready  cash  would  be. 
There  are,  consequently,  many  persons  who  would  be  and 
are  lenders,  without  any  further  payment  of  interest  than 
the  deposit  service  of  banks.  The  lending  involves,  in 
each  case,  only  such  waiting  as  is  convenient  and  as 
would  be  done  an)rway.  And  it  is  more  satisfactory  to 
have  the  bank  deposit,  thus  making  this  waiting  available 
as  lending,  than  to  keep  all  quick  assets  in  cash.  From 
the  side  of  the  ultimate  lenders,  there  is  no  difficulty  in 
seeing  how  bank  credit  may  be  substituted  for  money, 
to  a  large  extent,  with  advantageous  results.  It  should 
be  noted  that  the  ultimate  lenders  are,  by  making  their 
waiting  available  to  borrowers,  really  adding  to  the 
wealth-producing  efficiency  of  the  community.  Were 
it  not  for  this  bank  credit,  i.e.  this  combination  of 
sporadic  waiting,  borrowers  could  only  be  similarly 
provided  for  by  the  use  of  money.  But  a  quantity  of 
money  corresponding  to  such  possible  bank  credit,  sup- 
posing the  money  to  be  of  standard  money  metal,  e.g. 
gold,  would  be  a  tremendous  capital  investment  and 
would  involve,  therefore,  great  expense.  An  equivalent 
additional  investment  in  other  capital,  if  made  possible  by 
a  partial  substitution  of  safe  bank  credit  for  specie  money, 
is  more  profitable  to  the  community.  The  same  total 
amount  of  capital  is  thus  made  to  produce  larger  results. 
"^^^  Let  us  now  consider  the  interests  of  the  borrowers. 
^^^  They  also  will  be  ready  to  encourage  the  system,  because 
^l^it  enables  them  to  secure  loans  at  relatively  favorable 
rates.  The  banking  system  combines  and  coordinates, 
as  we  have  seen,  a  great  deal  of  waiting  which  would  be 
done  in  any  case.  This  it  puts  at  the  disposal  of  short- 
term  borrowers,  so  adding  to  the  supply  of  loans.  If 
borrowers  will  avail  themselves  of  these  loans,  which  will, 


36    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

obviously,  on  the  principles  already  set  forth,  take  chiefly 
the  form  of  bank  credit  rather  than  of  cash,  a  lower  rate 
of  interest  becomes  possible.  But  it  becomes  possible 
only  because  borrowers  are  making  use  of  waiting  which 
would  in  any  case  be  done,  only  because  such  use  enables 
society  to  get  along  with  less  of  other  currency,  pre- 
sumably with  less  of  gold,  and  so  enables  a  larger  amount 
of  society's  total  capital  to  be  held  in  other  forms.^ 

These  conclusions  apply  no  less  when  the  formal  ar- 
rangement is  somewhat  different.  Not  infrequently 
A  buys  goods  for  which  he  gives  his  promissory  note  to 
B.  B  endorses  this  note  and  deposits  it  with  his  bank, 
and  thereby  secures  a  deposit  account.  The  bank  is 
under  obligation  to  honor  B's  checks  upon  it  for  the 
amount  for  which  A's  note  was  discounted.  But  A  is 
under  obligation  to  pay  the  bank.  Taking  a  large 
number  of  such  transactions,  we  may  say  that  all  the 
makers  of  notes  so  deposited,  along  with  other  debtors 
to  banks,  are  in  debt  to  all  the  holders  of  bank  deposits, 
and  that  the  latter  are  creditors  of  the  former.  Business 
takes  place  by  means  of  different  persons  assuming,  suc- 
cessively, the  position  of  creditors,  through  the  banks  as 
intermediaries,  to  such  persons  as  A.  The  fact  that  spo- 
radic waiting  is  brought  together,  undoubtedly  tends  to 
give  A's  personal  note  more  value,  i.e.  makes  the  interest 

1  The  same  principle  applies  to  government  paper  money,  as  was  shown  in 
Chapter  I  (of  Part  I),  §  6.  In  that  case,  the  government  is  the  borrower  and 
pays  no  interest.  So  far  as  bank  credit  makes  impossible  the  issue  of  so  much 
paper  money  by  government,  the  lower  interest  to  borrowers  from  banks  does 
not  involve  economy  in  the  use  of  gold  and  lower  average  interest.  For  then 
the  government  itself,  having  to  borrow  by  issuing  more  bonds  than  would, 
perhaps,  be  necessary  if  it  issued  credit  money,  must  pay  interest  which,  other- 
wise, it  would  not  have  to  pay.  This  conclusion  does  not  mean,  of  course,  that 
inelastic  government  paper  money  is  to  be  preferred  to  elastic  bank  credit; 
nor  does  it  mean  that  government  paper  money  is  to  be  preferred  to  bank  credit, 
on  other  accounts. 


THE  NATURE  OF  BANK  CREDIT      37 

he  has  to  pay  somewhat  lower.  The  bank  can  give  more 
for  the  note  than  it  otherwise  could,  just  because  its  own 
creditors  will  not  all  want  cash  at  once,  just  because  its 
lending  power  (for  the  bank  is  making  itself  a  creditor  of 
or  lender  to  A)  is  made  greater  by  the  existence  of  the 
sporadic  waiting  which  it  has  combined ;  and  since  the 
bank  can  give  more  for  the  note  to  B,  B  can  give  more 
for  it  (in  goods)  to  A. 

The  principle  is  the  same  if  B  deposits,  not  A's  promis- 
sory note,  but  a  bill  (or  draft)  on  A,  payable  in  some  30 
or  60  days,  for  goods  shipped  to  A.  This  draft  will  be 
presented  to  A  for  his  signature  as  soon  as  possible. 
That  is,  A  will  be  expected  to  acknowledge  his  in- 
debtedness by  "accepting"  the  draft.^  The  bill  (or 
draft)  thus  becomes,  in  effect,  A's  promissory  note 
indorsed  by  B. 

In  Europe,  particularly  in  England,  still  another 
method  of  securing  bank  credit  is  common.  This  is  the 
method  of  bank  acceptances.^  The  would-be  borrower, 
A,  instead  of  directly  borrowing  of  his  bank  a  checking 
account,  or  instead  of  giving  his  creditor,  B,  a  promissory 
note,  for  deposit,  if  desired,  in  B's  bank,  or  instead  of 
having  B  make  out  a  draft  directly  upon  him,  gets  some 
bank  to  agree  to  '^ accept"  (i.e.  become  responsible  for 
the  payment  of)  drafts  which  B  may  draw  upon  this 
bank  up  to  an  agreed  amount.  A  can  then  pay  to  B 
whatever  is  owing  to  the  latter,  by  arranging  to  have  B 
draw  a  draft  upon  the  bank  with  which  the  agreement  has 

1  For  fuller  discussion  of  such  "bills  of  exchange"  and  their  security,  see 
Ch.  Ill  (of  Part  I),  §  7. 

'  For  a  description  of  acceptances  and  a  study  of  their  effects,  see  Lawrence 
Merton  Jacobs,  "Bank  Acceptances,"  National  Monetary  Commission,  igio. 
See  further,  also  in  National  Monetary  Commission,  Paul  M.  Warburg,  "The 
Discount  System  in  Europe,"  pp.  7-13. 


38    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

been  made.  The  bank  in  question  will  undertake  to 
pay  the  draft  when  it  becomes  due,  say  in  60  days.  But 
the  agreement  is  that  before  it  does  become  due,  A  shall 
provide  the  bank  with  the  necessary  funds.  The  bank 
with  which  the  agreement  is  made,  guarantees  payment 
to  B,  but  does  not  expect  to  draw  upon  its  own  resources 
in  making  such  payment.  B  can  deposit  the  draft  with 
his  own  bank  for  credit.  B  then  has  a  right  to  draw 
from  his  own  bank  on  demand ;  his  bank  has  a  claim  upon 
the  bank  with  which  A  made  the  above  described  arrange- 
ment; and  this  bank  has  a  claim  upon  A.  B,  or  those 
receiving  from  him  checks  upon  his  bank,  may  be 
regarded  as  the  ultimate  creditor  or  creditors;  A  is 
obviously  the  ultimate  debtor.  The  banks  are  inter- 
mediaries. Also,  the  banks  have  brought  together  the 
waiting  of  those  who  successively,  for  periods  dictated 
by  their  own  convenience,  become  creditors  of  the  bank- 
ing system  by  receiving  checks  or  deposit  rights  based 
on  the  draft  for  which  A  is  ultimately  responsible. 
Further,  the  fact  that  this  sporadic  waiting  is  made 
available  as  actual  lending,  means  that  B's  draft  on  the 
bank  will  be  discounted  at  a  somewhat  lower  rate  than  it 
otherwise  probably  could  be,  and  will  therefore  bring  a 
better  price.  Since  the  draft  for  a  given  sum  has  thus 
a  somewhat  higher  value  to  B  than  it  would  else  have,  the 
latter  will  be  ready  to  charge  A  in  payment  for  any 
definite  amount  of  goods  sold,  a  somewhat  lower  price 
than  otherwise.  In  effect,  because  of  the  waiting  made 
available  by  the  banking  system,  A  borrows  at  a  lower 
rate  of  interest.  The  same  principle  is  involved  if,  as 
frequently  happens,  A  himself  draws  a  draft  upon  a 
bank  which  agrees  to  "accept"  it,  and  sells  it  to  another 
bank  for  credit.    Those  who  receive  A's  checks  on  this 


THE  NATURE  OF  BANK  CREDIT      39 

credit,^  in  payment  for  goods,  are  then  the  ultimate 
lenders'in  the  sense  above  explained. 

Whatever  the  formal .  arrangement  by  which  bank 
credit  is  utiHzed,  the  charges  to  the  borrowers  or  debtors 
(for,  in  the  last  analysis,  it  is  always  the  borrowers  or 
debtors  who  pay)  must  be  enough  to  cover  the  cost  of 
banking  service.  These  charges  must  remunerate  the 
banks  for  concentrating  waiting  where  it  has  the  greatest 
usefulness.  They  must  cover  salaries  of  bank  officials, 
depreciation  of  bank  property,  interest  on  the  capital 
invested  by  the  banks  themselves,  and  compensation  for 
the  risk  to  the  banks,  of  insolvency,  for  the  banks,  though 
chiefly  go-betweens  or  intermediaries,  do  nevertheless 
insure  the  credit  of  borrowers.  If  all  the  borrowers 
failed  to  make  good,  the  banks  must  fail;  but  within 
limits  the  banks  can  and  do  guarantee  depositors.  This 
they  do,  largely,  by  maintaining  cash  reserves  of  per- 
haps Yo  to  i  of  their  deposits,  according  to  conditions 
and  the  requirements  of  law,  from  which  they  can  liqui- 
date as  many  of  their  demand  obligations  as  are  likely 
to  be  suddenly  presented  for  payment  at  any  one  time. 
On  these  reserves,  as  on  their  other  capital,  the  banks 
expect  to  realize  a  reasonable  interest. 

In  other  words,  the  payments  made  by  borrowers  must 
cover  the  cost  of  banking  plus  a  fair  return  on  banking 
capital.  These  payments  would  not  do  this  if  the 
demand  for  loans  from  banks  were  very  small,  and  if 
such  demand  could  be  sufficiently  met  by  the  funds  of 
depositors  who  would  be  willing  to  pay  the  cost  of 
banking,  for  the  sake  of  the  convenience  of  banking 
service.  The  demand  for  bank  loans,  however,  is  far 
in  excess  of  what  could  be  supplied  by  means  so  trivial, 
and  is,  indeed,  sufficient  to  throw  upon  borrowers  or 


40     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

debtors  as  such,  the  whole  cost  of  banking  service. 
When  those  who,  through  the  intermediation  of  banks, 
are  the  ultimate  lenders  or  creditors,  have  become  such 
by  having  the  promissory  notes  of  or  drafts  on  their 
debtors  discounted,  the  creditors  may  seem  to  be  paying 
the  cost  of  banking.  But,  in  such  cases,  they  have,  pre- 
sumably, made  allowances  for  the  bank  rate  of  discount, 
in  the  prices  they  have  charged  for  goods  sold,  and  the 
debtors,  therefore,  really  pay  for  the  services  of  the 
banks. 

The  payments  by  borrowers  or  debtors  may  be  re- 
garded, then,  as  real  interest  payments  in  the  sense  that 
the  ultimate  lenders  profit  by  the  existence  of  a  place  of 
deposit  other  than  their  own  vaults,  for  which  they  do 
not  have  to  pay,  and  profit  further  by  the  facility  of 
check  payments  thus  made  practicable.  If  no  money 
interest  is  received  by  the  ultimate  lenders,  the  amounts 
paid  by  borrowers  are,  in  the  long  run,  because  of  the 
competition  of  different  banks,  determined  by  the  labor 
cost  of  rendering  the  service,  plus  the  interest  (including 
compensation  for  risk)  on  the  cost  value  of  the  machinery, 
such  as  buildings,  necessary  reserves,  etc.,  used  in  bring- 
ing borrowers  and  real  lenders  together.  If,  however, 
there  is  not  a  sufficiency  of  this  '^ convenience  waiting" 
to  be  had  to  supply  the  demand  for  loans  at  the  mere 
cost  of  concentration,  then  the  banks  will  bid  against 
each  other,  not  so  much  to  cut  down  the  charge  for  the 
service  performed  for  borrowers,  as  to  get  deposits. 
Hence  we  are  beginning  to  see  direct  interest,  though  at 
low  rates,  very  generally  offered  on  deposits  subject  to 
check,  either  on  monthly  balances  or  otherwise. 


THE  NATURE  OF  BANK  CREDIT      41 

§5 
Application  of  Principles  Arrived  at,  to  Bank  Notes 

The  same  principles  apply  to  bank  notes  as  to  bank 
deposits.  The  bank  note,  when  issued  on  the  sole 
responsibility  of  a  bank,  is,  like  the  deposit,  a  credit 
obligation  of  the  bank  to  the  holder.  The  holder  is 
entitled  to  specie  or  other  legal  tender  money  on  demand. 
As  with  deposits,  these  rights  to  draw  circulate  from 
hand  to  hand  in  payment  for  goods.  And  as  with 
deposits,  the  real  lender  or  creditor  is  the  person  wl  o 
receives  the  bank  notes,  which  represent  only  a  claim 
in  payment  for  goods  sold;  while  the  ultimate  debtor 
is  the  person  —  or  the  persons  —  who  has  borrowed  the 
bank's  credit  in  this  form,  either  directly  or  by  any  of  the 
methods  just  described  in  relation  to  deposits,  and  is 
under  obligation  to  repay.  The  bank  is  a  legally  re- 
sponsible intermediary,  but  is  chiefly  dependent,  in  the 
long  run,  for  means  to  redeem,  on  repayment  of  loans  by 
its  debtors.  The  bank,  in  the  main,  is  merely  an  inter- 
mediary, although,  as  with  deposits,  part  of  its  own  cap- 
ital serves  as  an  insurance  fund  to  cover  all  contingencies 
which  are  reasonably  likely  to  occur. 

But  the  holders  of  bank  notes  are  frequently  given,  by 
government,  greater  protection  against  loss  than  the 
holders  of  deposits.  In  Canada,  for  example,  the  note- 
issuing  banks  have  to  contribute  to  a  special  reserve  fund . 
to  redeem  the  notes  of  failed  banks,  besides  which  note 
holders  have  a  prior  lien.  In  the  United  States,  note 
holders  are  insured  against  loss  by  the  Federal  govern- 
ment, which  makes  itself  ultimately  responsible  for  all 
notes  issued  in  conformity  with  the  national  banking 
law,  and,  therefore,  for  all  bank  notes  issued,  since  a 


42     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

lo  per  cent  tax  on  other  bank  notes  effectually  keeps  them 
out  of  circulation.  The  notes  issued  by  national  banks 
are  based  chiefly  ^  on  government  bonds.  Each  national 
bank  must  have  purchased  bonds  of  the  United  States, 
the  par  value  and  also  the  market  value  of  which  shall 
be  at  least  equal  to  all  its  notes  in  circulation.  These 
bonds  must  have  been  deposited  with  the  Comptroller 
of  the  Currency.  The  banks  must  also  have  deposited 
in  cash  a  redemption  fund  of  5  per  cent  of  the  face  value 
of  their  notes.  In  consideration  of  these  safeguards, 
the  United  States  assumes  ultimate  responsibility  for 
the  redemption  of  the  bank  notes  in  case  of  the  failure 
of  any  bank,  and,  in  fact,  undertakes  to  redeem  the  notes 
currently  for  those  persons  presenting  them,  out  of  the 
5  per  cent  redemption  fund.  These  bond-secured  bank 
notes  will,  however,  be  gradually  withdrawn  over  a  period 
of  years.  The  recent  Federal  Reserve  Act  permits  their 
gradual  retirement  and,  in  addition,  the  2  per  cent  gov- 
ernment bonds,  on  which  alone  they  can  be  based,  will, 
as  they  mature,  be  permanently  withdrawn.  The  recent 
Federal  Reserve  Act,  however,  creates  from  eight  to  twelve  ^ 
Federal  reserve  banks  through  which  Federal  reserve 
notes  shall  be  issued.  Back  of  these  the  Federal  reserve 
banks  must  keep  a  40  per  cent  gold  reserve,  of  which 
not  less  than  J,  or  5  per  cent,  shall  be  in  the  Treasury  of 
the  United  States.  These  notes  are  to  be,  in  each  case, 
a  first  lien  upon  the  assets  of  the  bank  through  which 
they  are  issued.  But  the  government  makes  itself 
ultimately  responsible  for  their  redemption.     The  notes 

1  The  provisions  of  the  Aldrich-Vreeland  emergency  currency  measure  will 
shortly  be  superseded  by  those  of  the  Federal  Reserve  Act  of  1913.  The  Aldrich- 
Vreeland  Act  cannot  be  availed  of  after  July  i,  1915.  The  new  law  is  already 
(August  1914)  being  put  into  operation. 

2  Made  twelve  by  the  Organization  Board. 


THE  NATURE  OF  BANK  CREDIT      43 

are  issued  to  the  Federal  reserve  banks  for  them  to  lend 
out,  at  the  discretion  of  the  Federal  Reserve  Board,  a 
government  regulating  body.  They  partake  in  part  of 
the  character  of  government  paper  money  and  in  part 
of  the  character  of  bank  notes.  It  is  customary  in 
European  countries  also,  to  safeguard  especially  bank 
notes  as  contrasted  with  deposits.  The  holder  of  a 
deposit  is  supposed  to  become  a  depositor  only  delib- 
erately and  after  consideration  of  the  financial  soundness 
of  his  chosen  bank.  But  bank  notes  circulate  from  hand 
to  hand  as  ''money,"  are  received  often  in  the  form  of 
wages  by  the  comparatively  poor,  and  are  not  usually 
scrutinized  to  see  from  what  bank  they  come;  nor  is 
the  soundness  of  the  bank  usually  considered. 

§6 

Quantitative  Statement  of  the  Relation  of  Money y  together 
with  Bank  Credit,  to  Prices 

The  foregoing  explanation  of  the  nature  of  commercial 
banking  operations  makes  clear,  it  is  hoped,  that  these 
operations  economize  the  use  of  money  and  why  they  do 
economize  such  use.  The  rights  to  draw  from  banks, 
thus  circulating  in  place  of  government  or  "lawful" 
money  (whether  these  rights  are  evidenced  by  checks 
or  by  bank  notes)  we  may  call  M\  and  the  average 
velocity  ^  with  which  they  circulate,  V\  Then  our 
equation  becomes  ^ 

MV  +  M'V  =  pq  +  p'q'  +  etc.^ 

1  Estimated  by  Fisher,  Purchasing  Power  of  Money,  p.  285,  as  averaging,  in 
recent  years,  towards  50. 

2  Stated  in  Ch.  I  (of  Part  I),  §  i,  without  the  inclusion  of  bank  credit. 

3  The  equation  of  exchange  has  been  so  stated  as  to  include  credit,  by  Kem- 
merer.  Money  and  Credit  Instruments  in  their  Relation  to  General  Prices,  New 
York  (Holt),  1907,  p.  75 ;  and  by  Fisher,  The  Purchasing  Power  of  Money 
p.  48. 


44    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  general  level  of  prices  is  somewhat  higher  and  the 
value  of  money  is  somewhat  lower,  because  of  the  addi- 
tional use  of  credit.  The  conditions  of  supply  and 
demand  require  a  somewhat  higher  level  of  prices,  just 
as  we  have  seen  that  they  do  when  there  is  more  money. 
Gold  is  cheaper.  The  demand  for  it  is  less.  It  does  not 
need  to  be  produced,  and  cannot  profitably  be  produced, 
at  such  a  low  margin,  i.e.  from  such  unfavorable  sources 
of  supply,  as  would  otherwise  be  worth  while.  But 
this  bank  credit  is  not  altogether  an  addition  to  currency ; 
it  decreases  the  amount  of  gold  money,  and  so  is  largely 
a  substitution  of  a  cheaper  for  a  dearer  currency. 

But  if  bank  credit  can  thus  take  the  place  of  money,  is 
there  any  Hmit  to  such  substitution?  Why  might  not 
credit  expand  and  prices  rise,  or  money  be  pushed  out, 
indefinitely?  The  answer  is  that  the  amount  of  bank 
credit  is  pretty  definitely  related  to  the  amount  of  money. 
In  the  first  place,  a  certain  amount  of  cash  is  needed  in  the 
banks,  to  maintain  confidence.  The  amount  so  needed 
bears  a  relation  to  the  amount  of  bank  credit,  and  must 
be  some  reasonable  per  cent  of  such  credit.  Otherwise, 
the  public  is  likely  to  become  frightened  and  demand  cash, 
and  this  cash  cannot  be  paid.  A  margin  against  such 
contingencies  is  always  essential  and,  for  national  banks 
of  the  United  States  and  Federal  reserve  banks,  as  well 
as  frequently  for  State  banks,  is  required  by  law.  Ref- 
erence has  just  been  made^  to  this  requirement  in  the  case 
of  the  Federal  reserve  notes.  So  the  total  bank  credit 
is  related  to  the  total  bank  reserves  or  cash  in  the  banks. ^ 
Banks  maintain  the  proper  relation  between  deposits 
and  reserves,  by  adjusting  their  rates  of  interest  (or  dis- 

1  §  5  of  this  chapter  (II  of  Part  I). 

2  White,  Money  and  Banking,  third  edition,  Boston  (Ginn),  1908,  p.  197 


THE  NATURE  OF  BANK  CREDIT      45 

count)  charged  to  borrowers.  If  the  deposits  are  in 
danger  of  becoming  too  great,  relative  to  the  reserves,  a 
higher  charge  to  borrowers  will' discourage  borrowing,  and 
so  will  limit  the  increase  of  those  deposits  which  originate 
in  the  borrowing  of  deposit  rights  (or  in  the  discounting 
of  notes  and  acceptances) . 

The  total  bank  credit  is  related,  also,  to  the  total  cash 
in  circulation.^  Bank  deposits  passed  by  means  of  checks 
are  absolutely  unavailable  for  very  many  transactions. 
They  are  unavailable  when  the  maker  of  a  check  is 
unknown,  and  they  are  unavailable,  practically,  for  small 
payments,  such  as  street  car  fares.  Even  bank  notes 
cannot  fill  up  the  entire  circulation  when,  as  is  usually 
the  case,  the  government  allows  them  to  be  issued  only 
in  relatively  large  denominations.  The  smaller  denomi- 
nations are  needed  and  government  money  is  used. 
Business  convenience,  then,  also  compels  a  relationship 
between  the  quantity  of  bank  credit  and  the  quantity  of 
government  money. 

Since  the  quantity  of  bank  credit  is  related  in  these 
two  ways  to  the  quantity  of  government  coined  and 
government  issued  money,  changes  in  the  latter  tend  to 
bring  proportionate  changes  in  the  former.  It  is  still 
true  that  prices  depend  upon  the  quantity  of  money, 
though  the  dependence  is  in  part  indirect.  The  demand 
for  goods  comes  from  those  who  have  bank  credit  to 
offer  as  well  as  from  those  who  have  only  money.  And  we 
may  now  speak,  not  merely  of  the  supply  of  money  and 
the  demand  for  it,  but  of  the  supply  of  currency  (includ- 
ing both  money  and  circulating  credit),  and  the  demand 
for  it. 

*  Fisher,  The  Purchasing  Power  of  Money,  p.  50. 


46    THE  EXCHANGE  MECHANISM  OF  COMMERCE 


Fluctuations  of  Bank  Credit 

But  though  the  amount  of  bank  credit  is  thus  related 
to  the  amount  of  money,  the  ratio  between  them  is 
slightly  rhythmic  rather  than  definitely  constant. 
During  periods  of  hope  and  confidence,  bank  credit 
tends  to  expand,  and  prices  to  rise.  During  periods  of 
distrust  and  depression,  the  volume  of  circulating  credit 
tends  to  be  smaller,  and  prices  to  be  lower.  When 
prosperity  is  generally  expected,  business  men  are 
anxious  to  extend  their  credit  by  borrowing  of  the  banks 
for  the  purchase  of  merchandise  and  for  other  business 
purposes.  The  banks  can  then  increase  their  deposits 
by  making  loans,  as  much  as  their  available  reserves  will 
permit.  When,  for  any  reason,  doubt  and  fear  prevail, 
even  low  discount  rates  may  not  induce  an  equal  amount 
of  borrowing. 

The  sharpest  changes  in  the  relation  of  the  quantity  of 
circulating  bank  credit  to  the  quantity  of  money  come  as 
the  consequence  of  panic.  So  far  as  a  panic  is  foreseen, 
the  banks  endeavor  to  prepare  themselves  for  it  by 
decreasing  their  demand  liabilities  in  relation  to  their  cash 
on  hand  or  reserves.  That  is,  they  cut  down  their  loans 
by  raising  their  rates  of  discount.  As  the  panic  spreads, 
the  necessity  of  such  a  policy  becomes  evident  to  nearly 
all  the  banks.  Any  bank  may  suddenly  find  itself  sub- 
jected to  the  danger  of  a  run  upon  it,  and  dares  not 
increase  the  danger  by  making  extensive  loans.  Those 
banks  upon  which  there  actually  are  runs,  find  themselves 
with  depleted  reserves,  and  are  peculiarly  unable  to 
extend  credit.    The  bank  rate  of  discount,  then,  rises 


THE  NATURE  OF  BANK  CREDIT      47 

rapidly,  while  the  volume  of  bank  credit,  if',  decreases, 
and  prices  fall. 

At  such  a  time  of  stress,  a  great  national  bank  (or  a 
few  great  banks)  which  keeps  large  reserves  beyond  the 
requirements  of  ordinary  years,  is  a  tower  of  strength, 
and  can  usually  prevent  any  general  collapse  of  credit. 
Such  an  institution  is  the  Bank  of  England,  which  holds 
itself  responsible  for  the  credit  structure  of  the  nation, 
and  maintains  always  an  emergency  reserve.  In  the 
United  States,  the  recent  Federal  Reserve  Act  (of  1913) 
directs  the  estabHshment  of  not  less  than  eight  or  more 
than  twelve  ^  Federal  reserve  banks.  All  national  banks, 
and  all  other  banks  which  become  members  of  the 
system,^  are  required  to  keep  a  portion  of  their  reserves 
in  one  of  the  Federal  reserve  banks.  The  aim  is  to  have  a 
large  part  of  the  nation's  banking  reserve  concentrated 
in  these  few  large  banks  so  that  ample  means  may  be 
available  in  time  of  panic  for  the  aid  of  any  sound  bank 
which  finds  itself  threatened  by  the  unreasoning  fear  of 
depositors.  The  Federal  reserve  banks  are  themselves 
required  to  keep  each  a  35  per  cent  reserve  in  lawful 
money  against  deposits  and  a  40  per  cent  reserve  in  gold 
against  the  Federal  reserve  notes  which  they  have  out- 
standing. This  requirement  insures  the  maintenance 
in  ordinary  times  of  a  reserve  which  may  be  needed 
in  case  of  a  financial  crisis.  But  when  there  is  financial 
crisis  or  the  fear  of  it  and  many  banks  are  curtailing 
their  loans,  one  of  the  things  most  needed  is  the  assurance 
that  credit  can  be  secured  by  those  whose  assets  are  good 
and  whose  business  is  dependent  upon  credit.  At  such 
a  time  new  reservoirs  of  credit  may  need  to  be  opened 

1  Made  twelve  by  the  Organization  Board. 

'  With  a  temporary  exception  stated  in  the  act. 


48    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

until  the  old  ones,  temporarily  closed,  are  again  un- 
locked. The  new  law  therefore  provides  that  the 
Federal  Reserve  Board,  the  government  regulating 
body,  may  temporarily  suspend  any  of  the  reserve  re- 
quirements, but  only  by  levying  a  proportional  tax  on 
the  banks  so  favored. 

But  while  it  is  desirable  that  the  violent  credit  fluc- 
tuations associated  with  crises  should  be  avoided,  some 
seasonal  rise  and  fall  of  bank  credit  is  desirable.  In 
agricultural  countries,  particularly,  the  amount  of  trade 
immediately  after  the  crop  season  is  greater  than  at  other 
times,  and  an  alternate  expansion  and  contraction  of 
bank  credit,  corresponding  to  the  expansion  and  contrac- 
tion of  business,  tends  to  keep  prices  more  stable  rather 
than  to  make  them  less  so.  In  the  United  States,  the 
circulation  of  the  Federal  reserve  notes  provided  for  in 
the  new  currency  bill,  and  the  gradual  retiring  of  the  old 
bond-secured  bank  notes,  will  tend  to  an  elasticity  of  bank 
credit  in  the  form  of  notes,  comparable  to,  though  perhaps 
less  than,  the  elasticity  of  deposits.  The  new  law  requires 
that  no  Federal  reserve  notes  originally  issued  by  one 
Federal  reserve  bank  shall  be  paid  out  by  another  such 
bank  but  shall  be  sent  promptly  for  credit  or  redemption 
to  the  issuing  bank.  The  effect  of  this  provision  must 
be  to  give  at  least  some  slight  elasticity  to  the  volume  of 
these  notes.  For  the  notes  will  be  lent  out  as  business 
conditions  favor,  and  will  pass  into  circulation.  They 
will  then  be  used  by  borrowers,  along  with  other  means 
of  payment,  to  liquidate  debts  to  the  various  banks,  will 
flow  in  considerable  volume  to  the  Federal  reserve  banks, 
and  must  then  be  cancelled  against  other  debts  or  re- 
deemed. Bank  deposits  in  the  United  States  are  nor- 
mally elastic,  and  will  doubtless  continue  to  be  so.    The 


THE  NATURE  OF  BANK  CREDIT      49 

banks  lend  perhaps  nearly  all  their  reserves  will  support, 
at  certain  times,  and  at  other  times  accumulate  reserves 
in  preparation  for  the  season  or  seasons  of  largest  lending. 

§8 

Summary 

Let  us  now  bring  together,  in  brief  compass,  the  main 
conclusions  of  this  chapter.  We  saw,  to  begin  with,  that 
credit  does  not  really  act  as  a  substitute  for  money  unless 
there  is  the  possibility  of  cancellation,  unless  the  same 
credit  (though  not  necessarily  the  same  paper  evidence 
of  it)  circulates  more  than  once.  It  usually  does  this 
in  the  case  of  the  bank  deposit  or  right  to  draw  from  a 
bank.  This  right  to  draw,  circulating  by  check  or  draft, 
is  a  substitute  in  trade  for  legal  tender  money,  tends 
somewhat  to  increase  the  total  supply  of  currency,  and 
tends  to  drive  out  other  currency. 

Analysis  of  the  relations  of  the  various  parties  con- 
cerned, to  each  other,  showed  that,  apart  from  their 
function  of  insuring  the  credit  of  borrowers  by  risking 
some  capital  of  their  own,  banks  are  really  but  inter- 
mediaries between  those  who  borrow  of  them,  and  the 
real  lenders.  These  lenders  are  the  depositors,  since  it  is 
the  depositors  who  have  given  up  present  goods  by  de- 
positing, in  the  banks,  money  which  they  might  have 
spent,  by  accepting  checks  in  return  for  goods  sold, 
or  by  receiving  the  promissory  notes  of  or  drawing  drafts 
on  the  purchasers  of  the  goods,  and  having  such  notes 
or  drafts  discounted  by  banks.  If  the  borrowers  as  a 
whole  were  unable  to  repay,  then  the  banks  would  be 
unable  to  pay  the  depositors  what  the  latter  were  entitled 
to.     What  the  banks  do  is  to  bring  together  borrowers 


so    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

and  lenders,  making  available  to  borrowers,  in  the  form 
of  loans,  sporadic  waiting  which  would  in  any  case  exist. 
Through  the  institution  of  commercial  banking,  trade  is 
carried  on  by  means  of  people  becoming  successively 
and  alternately  each  other's  creditors.  The  demand  for 
loans  from  borrowers  is  sufficient  to  throw  upon  them  the 
cost  of  maintaining  the  banking  system.  Nevertheless, 
the  existence  of  that  system,  by  making  possible  the 
bringing  together  of  sporadic  waiting,  tends  to  make  the 
interest  charge  to  borrowers  lower  than  it  would  probably 
otherwise  be.  Bank  notes  involve  the  same  principles 
as  bank  deposits,  though  the  holders  of  bank  notes  are 
commonly  protected  or  insured  to  a  greater  degree  by 
government  than  depositors. 

Bank  credit  is  related  to  the  quantity  of  money  by  the 
habits  and  business  requirements  of  the  community  and 
by  the  necessity  of  a  sufficient  reserve.  But  the  relation 
between  bank  credit  and  money  is  rhythmic  rather  than 
exactly  constant.  The  fluctuations  seem  to  be,  in  large 
part,  closely  connected  with  the  alternation  of  business 
confidence  and  business  distrust,  and  with  the  occurrence 
of  panics.  The  banking  system  should  be  so  well 
organized  and  conservatively  managed  as  to  minimize 
such  fluctuations  of  credit.  On  the  other  hand,  a  certain 
degree  of  elasticity  in  bank  currency,  making  it  expand 
and  contract  according  to  the  seasonal  variations  of  trade, 
appears  to  be  desirable. 


CHAPTER  III 
The  Nature  and  Method  of  Foreign  Exchange 

§1 

The  Function  of  Bills  of  Exchange 

In  the  last  chapter  we  saw  that  in  the  most  highly 
civilized  countries,  particularly  the  Enghsh-speaking 
countries,  the  largest  part  of  trade  is  carried  on  by  means 
of  bank  credit.  This  form  of  credit,  circulating  by  means 
of  checks,  is,  in  the  United  States,  of  almost  universal 
use  as  to  all  large  scale  dealings  within  a  city  or  other 
circumscribed  area. 

We  saw,  also,  that  the  use  of  this  bank  credit,  through 
checks  or  bank  notes,  is  merely  a  means  by  which  bor- 
rowers and  lenders  are  brought  together,  the  bank 
being  but  an  intermediary ;  that  it  is  a  means  by  which 
one  person  or  firm  can  become,  in  the  sense  explained  in 
the  preceding  chapter,  a  debtor  successively  to  a  second, 
third,  fourth,  fifth,  etc.,  so  that  money  has  only  to  pass 
from  the  first  through  the  bank  or  through  two  or  more 
banks  and  a  clearing  house,  to  the  last.  All  the  inter- 
mediate transactions  may  then  cancel,  or  cancellation 
may  at  times  be  complete,  so  that  no  balance  remains. 
Cancellation  of  these  serial  and  opposing  debts  thus  be- 
comes our  principal  means  of  carrying  on  modern  busi- 
ness. And  trade  is  still,  in  the  last  analysis,  as  in  primi- 
tive barter  or  as  where  money  is  the  medium,  an  exchange 
of  goods  for  other  goods.     We  buy  goods  and  become,  in 

SI 


52     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

effect,  debtors.  We  sell  goods  and  become  creditors. 
The  debts  cancel  and  we  have  traded  goods  for  goods. 

Bills  of  exchange  enable  us  to  extend  this  system  of 
credit  beyond  the  town  or  city,  beyond  the  state,  beyond 
the  nation.  Business  firms  separated  hundreds  of  miles 
from  each  other  can  become  debtors  and  creditors  of  one 
another  through  the  intermediation  of  the  banking  and 
exchange  system.  The  credit  structure  becomes  inter- 
national. Through  the  commercial  and  the  exchange 
banks,  a  New  York  firm  can  become,  in  effect,  suc- 
cessively the  debtor  of  a  London  firm,  another  London 
firm,  a  Glasgow  firm,  a  Berlin  firm,  a  Boston  firm,  and 
another  New  York  firm.  That  is,  these  different  business 
houses  successively  become  claimants  of  the  banking 
system,  through  their  receipts  of  checks  or  drafts  from 
one  another,  or  through  their  drawing  bills  of  exchange 
on  one  another,  or  both,  of  the  sum,  or  part  of  it,  originally 
borrowed  from  a  New  York  bank,  as  a  deposit,  by  the 
first  mentioned  New  York  firm.  In  trade  between 
nations,  or  between  widely  separated  parts  of  the  same 
nation,  credit  is  used,  debts  in  large  part  cancel,  and 
money  is  used  to  a  relatively  small  degree. 

Bills  of  exchange  or  drafts  serve  in  large  part,  then,  the 
same  purposes  as  ordinary  checks.  Over  long  distances, 
however,  whether  business  crosses  national  boun- 
daries or  not,  the  ^'customer's  check"  is  not  likely  to  be 
satisfactory.  The  receiver  may  have  hard  work  to  cash 
it  or  to  get  for  it  an  immediate  addition  to  his  bank 
balance.  In  the  distant  locality  to  which  the  check  is 
sent,  nobody,  probably,  knows  the  maker  well,  or  knows 
whether  the  maker's  check  is  good.  In  this  regard,  the 
bank  draft  is  superior.  Or  the  creditor  may  not  wish 
to  wait  for  what  is  owed  to  him,  until  a  check  arrives 


METHOD  OF  FOREIGN  EXCHANGE  53 

from  his  debtor.     In  this  regard,  a  commercial  draft  is 
superior. 

Foreign  and  domestic  exchange  are  in  principle  the 
same.  The  former  involves  payments  between  persons 
in  different  countries,  countries  which  have,  generally, 
different  currencies  and  which  are  often  separated  from 
each  other  by  natural  barriers.  Domestic  exchange  in- 
volves dealing  between  different  parts  of  the  same  coun- 
try, but  parts  too  far  from  each  other  for  the  ordinary, 
convenient  use  of  checks. 

§2 

The  Nature  of  Bills  of  Exchange 

Let  us  now  inquire  what  is  the  nature  of  the  bill  of 
exchange.  Suppose,  to  take  the  simplest  possible  case, 
that  B  owes  to  A  the  sum  of  $1000,  and  that  A  owes  a  like 
sum  to  C.  The  form  of  settlement  will  be  that  of  the 
bill  of  exchange  if  A  orders  B  to  pay  C.  When  B  compKes 
with  the  order,  his  debt  to  A  and  A's  debt  to  C  are  both 
liquidated.  Usually  the  bill  of  exchange  involves  an 
exchange  banker  or  broker  as  one  of  the  parties.  But 
in  any  case  it  is  always  of  the  form :  A  orders  B  to  pay  C. 

The  reader  may  at  once  note  that  in  so  far  the  bill  of 
exchange  resembles  the  ordinary  check,  which  is,  in  fact, 
but  one  species  of  bill  of  exchange.  But  a  distinction  can 
be  made,  based  partly  upon  the  relation  of  a  bank  or 
banks  to  others  concerned.  In  the  case  of  the  "  custom- 
er's check,"  A,  the  drawer,  is  a  mercantile  or  industrial 
establishment  or  a  person,  while  B,  the  drawee,  is  always 
a  bank.  In  the  case  of  the  commercial  draft,  A  and  B 
are  usually  persons,  or  commercial  or  industrial  establish- 
ments (except  that,  as  with  the  "bank  acceptances"  de- 


54    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

scribed  in  the  previous  chapter/  B's  bank  may  be  desig- 
nated by  him  as  the  drawee  in  his  place),  while  C,  the 
payee,  is  usually,  though  not  necessarily,  a  bank.  In 
the  case  of  the  hank  draft,  both  A,  the  drawer,  and  B, 
the  drawee,  are  banks.  The  payee  may  be  a  person  or 
an  ordinary  business  firm.  Furthermore,  a  check  is 
always  a  demand  claim  (a  demand  draft  of  one  bank  on 
another  is  frequently  called  a  ''check"),  while  a  draft 
may  or  may  not  be.  We  shall  have  occasion  to  notice, 
later  on,  the  significance  of  some  of  these  different  re- 
lations. What  we  have  here  to  emphasize  is  that  the 
bill  of  exchange  or  draft  and  the  ordinary  check  are 
exactly  alike  in  involving  three  parties,  of  whom  one 
orders  a  second  to  pay  a  third ;  and  that  the  distinction 
rests,  in  part,  upon  the  position  which  the  bank  or  banks 
concerned,  if  any,  occupy  in  relation  to  the  other  persons 
or  person. 

§3 

How  Bills  oj  Exchange  Might  he  Used  to  Settle  Ohligations, 
Assuming  no  Banks 

If  credit  is  to  serve  appreciably  as  a  medium  of  ex- 
change or  substitute  for  money,  then  when  credit  is  given 
there  must  generally  be  three  parties.  When  there  are 
but  two  persons  concerned,  the  giving  of  credit  is  usually 
only  a  postponement  of  payment.  There  is  not  an' 
avoidance  of  the  use  of  money,  except  in  those  com- 
paratively rare  cases  where  B's  debts  to  A  now  are 
balanced,  or  partly  balanced,  by  later  obligations  incurred 
by  A  to  B.  Then,  of  course,  credit  may  lead  to  cancella- 
tion. If  three  or  more  persons  are  concerned,  in  addition 
to  banks  or  other  intermediaries  (and  even  if  banks  are 

1  §  4  of  Ch.  II  (Part  I). 


METHOD  OF  FOREIGN  EXCHANGE  55 

included  in  the  three,  this  would  be  true  in  form),  can- 
cellation always  takes  place. 

But  we  have  yet  to  see  just  how  bills  of  exchange  or 
drafts  are  used  to  balance  obligations  in  foreign  trade. 
To  begin  with,  we  shall  take,  as  being  the  simplest,  a  case 
seldom  realized  in  practice,  namely,  where  four  parties 
can  settle  up  their  various  debts  without  resort  to  any 
bank,  exchange  broker,  or  other  go-between.  Suppose 
that  an  American  merchant,  whom  we  shall  designate 
as  Ai,  owes  to  an  English  manufacturer,  Ei,  the  sum  of 
£100  ($486.65),  while  the  latter  owes  as  much  to  an 
English  merchant,  Eo,  who  in  turn  owes  an  equal  sum  to 
an  American  manufacturer,  A2.  We  may  represent 
the  situation,  graphically,  as  follows : 


Ai > 


owes 


f 


owes 


owes 


Obviously,  if  the  parties  all  know  each  other  and  know 
of  the  situation,  they  can  very  easily  settle  all  three 
debts  with  but  one  use  of  money.  Ei  may  make  out  a 
bill  on  Ai  ordering  him  to  pay  E2.  Thus  Ei  cancels 
his  debt  to  E2.  E2  may  then  indorse  the  bill,  making 
it  payable  to  A2,  thus  Hquidating  his  (E2's)  debt  to  A2. 
Finally,  A2  presents  the  bill  to  Ai,  who  cancels  his  debt 


56     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

to  El  by  paying  it.  Thus,  three  debts  have  been  paid 
with  but  one  use  of  money.  Suppose  that,  in  addition 
to  the  other  debts,  A2  owes  $486.65  to  Ai.  Then  our 
diagram  would  be : 

Ai ^ — —  o^«5 5 E, 

I  1 

CM^  owes 

[  f 

At  < -"^ ^ Ea 

A2  might  then  pay  by  indorsing  the  bill  to  Ai,  who  would, 
therefore,  have  only  to  pay  himself.  In  that  case,  four 
debts  would  be  settled  with  no  use  of  money  at  all. 

§4 

Settlement  of  Obligations  by  Drafts  (Bills  of  Exchange), 
through  Intermediation  of  Banks,  Assuming  Creditors 
to  Draw  Drafts  on  Debtors 

Our  illustration,  however,  must  be  modified  if  it  is  to 
picture  the  usual  commercial  practice.  The  different 
parties  having  occasion  to  use  or  to  pay  drafts  or  bills  of 
exchange  cannot  be  expected,  ordinarily,  to  know  each 
other.  They  must  therefore  deal  with  middlemen,  with 
the  so-called  exchange  bankers  or  exchange  brokers. 
When  foreign  exchange  is  carried  on  through  the  inter- 
mediation of  bankers  or  exchange  brokers,  each  bill  of 
exchange  is  still  of  the  form,  A  orders  B  to  pay  C.     But 


METHOD  OF  FOREIGN  EXCHANGE  57 

an  exchange  banker  is  now  in  the  position  of  both  A 
and  B,  or  of  C. 

There  are  several  ways  by  which  debts  can  be  settled 
through  the  use  of  the  exchange  banking  machinery. 
One  way  is  for  the  creditor  to  draw  upon  the  debtor, 
ordering  him  to  pay  a  bank.  Another  is  for  the  debtor 
to  remit  to  the  creditor  by  sending  the  latter  a  bank 
draft.  Let  us  take  up,  first,  cases  where  the  creditor 
draws  on  the  debtor.  We  will  suppose  the  same  four 
persons,  Ai,  A2,  Ei  and  E2,  but  will  now  assume  what 
is  the  usual,  if  not  indeed  the  universal,  fact,  that  they 
deal  with  each  other  through  middlemen.  These  middle- 
men may  be  two  banking  houses  dealing  in  foreign 
exchange,  one,  Ba,  an  American  bank,  and  the  other.  Be, 
an  English  bank.  We  shall  suppose,  as  before,  that  Ai 
owes  El,  El  owes  E2,  E2  owes  A2,  and  A2  owes  Ai.  All 
that  is  needed  for  cancellation  is  that  the  parties  be 
brought  together.     Diagrammatically  this  situation  is: 


El  makes  out  a  draft  on  Ai  ordering  Ai  to  pay  Bg.  Ei 
may  be  said  to  sell  this  draft  to  Be.  Ei's  bank,  Bg,  may 
then  give  Ei  the  money,  but  will  more  probably  (since 
El  is  likely  to  prefer  it)  put  the  amount  to  his  credit  as 


58    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

a  depositor.  Bg  sends  this  draft,  directly  or  indirectly, 
to  Ba  for  collection.  Ba  will  subtract  it  from  the  credit 
account  of  its  customer,  Ai.  So  far,  no  money  has  been 
used.  El  has  an  addition  to  his  deposit  account.  Ai 
has  suffered  a  subtraction  from  his.  Ei  has  the  claim 
on  the  banks  which  Ai  has  lost.  Ei  may  now  settle 
his  obligation  to  E2  by  a  check  on  Bg.  E2  then  reahzes 
an  addition  to  his  deposit  account  with  Bg,  while  Ei 
suffers  a  diminution  of  his  bank  account.  Next,  A2  may 
make  out  a  draft  on  his  debtor,  E2  (or,  as  where  E2  has 
arranged  for  "acceptances,"  directly  on  E2's  bank), 
ordering  E2  (or  his  bank  for  him)  to  pay  Ba.  Ba  may  send 
this  draft  to  Bg  for  collection.  A2  now  has  an  addition 
to  his  deposit  account  in  Ba.  E2's  bank  account  is 
decreased.  Lastly,  A2  settles  with  Ai  by  check  on  Ba. 
Ai  has  now  an  addition  to  his  bank  account  which  may 
cancel  the  original  subtraction,  while  A2  suffers  a  sub- 
traction which  may  be  equal  to  the  previous  addition. 
Four  debts  may  have  been  cancelled,  with  no  use  of 
money.  In  any  case,  there  has  been  less  use  of  money 
because  of  the  use  of  drafts,  for  the  banks  concerned  com- 
pare accounts,  and  only  net  balances  have  to  be  paid  in 
money  or  in  gold.  The  use  of  bills  of  exchange  extends 
to  trade  between  nations,  and  equally  to  trade  between 
widely  separated  parts  of  the  same  nation,  the  operation 
of  the  bank  credit  system. 

Even  if  we  suppose  that  Ba  (for  example) ,  the  exchange 
bank  which  collects  the  draft  on  Ai,  is  not  the  bank  in 
which  Ai  regularly  keeps  a  deposit  account,  nevertheless 
the  rule  that  trade  is  carried  on  by  a  cancellation  of 
credits,  still  holds.  Though  Ba,  upon  receiving  from  Bg 
the  draft  drawn  by  Ei  upon  Ai,  cannot  then  directly 
subtract  the  amount  from  Ai's  account,  it  can  call  on  Ai 


METHOD  OF  FOREIGN  EXCHANGE  59 

for  payment.  Either  the  draft  will  be  made  payable 
to  Ai's  bank  and  by  that  bank  subtracted  from  his  deposit 
there,  or  it  will  be  presented  directly  to  Ai  himself,  in 
which  case  he  will  probably  pay  it  by  giving  Ba  a  check 
on  his  own  bank.  In  any  case,  then,  Ei's  bank  account 
will  probably  be  increased  and  Ai's  bank  account  de- 
creased by  virtue  of  the  draft. 

On  the  other  hand,  A2's  bank  account  will  be  increased 
when  he  sells  his  draft  on  E2,  though  he  sells  this  draft 
to  an  exchange  dealer  not  engaged  in  a  regular  banking 
business.  For  such  an  exchange  dealer  will  presumably 
pay  him  for  his  draft  by  means  of  a  check  upon  some 
bank,  which  he  can  then  deposit  for  credit  in  his  own 
bank.  His  deposit  account  is  increased  and  E2's  is 
decreased  by  the  transaction.  In  any  case,  Ba,  or  some 
other  exchange  bank,  has  to  pay  A2,  directly  or  indirectly, 
and  receives  payment,  directly  or  indirectly,  from  Ai ; 
in  any  case,  Ba  collects  one  draft  for  Be  and  sends  one 
draft  to  Be  for  collection.  In  any  case,  there  is  cancella- 
tion, and  the  shipment  of  gold  is  wholly  or  partially 
avoided.  A2  may  pay  Ai  by  check  as  above  suggested, 
or,  if  they  are  widely  separated,  Ai  may  draw  a  domestic 
draft  on  A2  and  deposit  the  draft  in  his  bank  for  credit. 
The  draft  will  go  to  A2's  bank  or  to  A2  for  collection  and 
A2's  bank  account  will  be  decreased. 

Attending  only  to  the  international  relations  involved, 
we  may  say  that  A2's  draft  on  E2  constitutes  part  of  the 
supply,  in  the  United  States,  of  bills  on  England.  The 
desire  of  an  American  bank,  e.g.  Ba,  to  purchase  this  bill, 
signifies  a  demand,  in  the  United  States,  for  bills  on  Eng- 
land. This  demand  may  be  said,  in  the  last  analysis, 
to  result,  partly,  from  the  necessity  which  some  American 
bank  (or  banks)  is  under,  of  remitting  to  an  English 


6o    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

bank  or  banks,  after  collecting  for  the  latter;  and  so 
may  be  said  to  result,  to  some  extent,  from  the  supply, 
in  England,  of  commercial  drafts  on  Americans.  We 
may  assert,  therefore,  that  the  supply  of  such  commercial 
bills  on  America,  in  the  English  market,  corresponds,  in 
part,  to  demand  for  bills  on  England,  in  the  American 
market,  and,  in  part,  gives  rise  to  this  demand.  The 
basic  principle  is  of  course  similar  in  the  relations  between 
different  parts  of  the  same  country.  In  general,  supply 
in  one  place,  of  commercial  bills  on  another,  gives  rise  to 
demand  in  the  other,  for  bills  on  the  first. 

To  avoid  misunderstanding,  it  should  be  pointed  out 
that  foreign  exchange,  in  the  compHcations  of  practical 
business,  is  often  three  cornered,  four  cornered,  etc., 
involving  merchants  and  banks  of  several  countries. 
Thus,  Americans  may  have  purchased  goods  of  English 
merchants ;  the  latter  may  have  bought  goods  in  Ger- 
many ;  and  Germans  may  have  imported  goods  from  the 
United  States.  Supposing  the  creditors  in  each  case 
to  draw  upon  their  debtors,^  there  would  be  sold  in  Eng- 
land, drafts  on  merchants  in  the  United  States; 
in  Germany,  drafts  on  English  purchasers;  and  in 
the  United  States,  drafts  on  Germans.  The  drafts 
in  England,  on  Americans,  would  be  sent  to  American 
banks* for  collection.  The  American  banks  must  then- 
settle  with  their  English  correspondents.  This  would 
create  a  demand  for  drafts  on  foreign  countries,  but 
might  not  directly  create  a  demand  for  drafts  on 
England.  For  the  American  banks  might  purchase 
drafts  on  Germany  and  send  these  in  settlement  to  their 
correspondents  in  England.  These  drafts  would  be 
collectible  through  German  banks,  which  might  settle 

1  See,  however,  §  5  of  this  chapter  (III  of  Part  I). 


METHOD  OF  FOREIGN  EXCHANGE  6i 

by  purchasing,  and  sending  to  their  EngKsh  correspond- 
ents, the  drafts  on  England  drawn  by  German  exporters. 
In  practice,  then,  the  supply  in  England  of  drafts  on  the 
United  States  may  not  directly  give  rise  to  a  demand  in 
the  United  States  for  drafts  on  England.  Instead,  it 
may  lead  to  a  demand  in  the  United  States  for  drafts  on 
Germany,  and  to  a  demand  in  Germany  for  drafts  on 
England.  These  complications  should  not  be  over- 
looked, but,  since  they  introduce  no  new  principle,  they 
may,  for  simpKcity,  be  ignored  in  most  of  our  study.  ^ 

§5 

Settlement  of  Obligations  by  Bank  Drafts,  when  Debtors 
Remit  to  Creditors 

Obligations  between  persons  in  widely  separated  places 
may  also  be  cancelled  through  the  use  of  bank  drafts. 
Instead  of  creditors  drawing  on  their  debtors,  the  debtors 
then  remit  to  their  creditors.  What  method  shall  be 
adopted  in  each  case  will  depend  upon  the  understanding 
between  the  parties  concerned  as  creditor  and  debtor. 
If  Ai  owes  El  and  is  to  pay  by  means  of  a  bank  draft, 
he  may  go  to  the  bank,  Ba,  and  request  such  a  draft 
payable  to  Ei.  This  he  will  pay  for  out  of  his  deposit 
with  Ba,  or  by  a  check  on  whatever  bank  he  has  an 
account  with,  or  (conceivably  but  rarely)  with  money. 
The  draft  Ai  gets  is  really  a  kind  of  check  made  out  by 
one  bank  on  another.  Ba  makes  out  an  order  upon  Bg 
(or  some  other  English  bank)  requiring  payment  to  Ei. 
This  order  is  handed  by  the  American  bank  to  Ai,  who 
sends  it  to  Ei,  and  the  last  named  person  is  then  in  a 
position  to  present  the  draft  for  cash  or,  more  probably, 
credit,  to  Be  or  to  his  regular  deposit  bank.    E2  may  simi- 


62     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

larly  settle  with  A2  by  getting  a  draft  from  Be  ordering 
Ba  to  pay  A2.  We  may  suppose  Ei  to  settle  with  E2  and 
A2  with  Ai  by  check,  as  before.  Or  we  may  suppose  that 
they  are  separated  from  each  other  by  considerable  dis- 
tances and  Hkewise  settle  witli  each  other  by  using  bank 
drafts.  The  matter  of  form  is  unessential.  In  any  case, 
most  obhgations,  both  international  and  intranational, 
can  be  settled  by  cancellation,  through  the  banks. 
/^    Where  settlement  is  made  by  the  use  of  bank  drafts, 

<  there  must,  of  course,  be  some  arrangement  between  the 
banks  concerned,  such  as  deposit  accounts  kept  by  each 
y  with  the  other,  so  that  all  of  these  drafts  will  be  honored 
^without  question.  There  is  no  need  of  any  special 
arrangement  in  the  case  of  checks,  since  these  can  be  sent 
at  once,  and  with  no  appreciable  loss  of  time  in  transit, 
through  a  clearing  house,  to  the  bank  on  which  they  are 
drawn.  But  with  bank  drafts,  used  where  the  distances 
are  greater,  the  situation  is  otherwise. 

Where  bank  drafts  are  used,  these  constitute  part  of 
the  supply  of  drafts,  and  the  demand  for  them  is  a  demand 
by  persons  and  by  business  houses,  who  have  remittances 
to  make,  as  well  as  by  banks.  Thus,  a  part  of  the  supply, 
in  the  United  States,  of  bills  on  England  is  made  up  of 
the  drafts  of  American  upon  EngHsh  banks ;  and  a  part 
of  the  demand,  in  the  United  States,  for  bills  on  England 
is  the  demand  for  bank  drafts,  by  business  houses  having 
obligations  to  meet  in  England  and  desiring  to  meet 
them  in  that  way. 

Third,  cancellation  may  take  place  by  the  use  of  both 
of  these  methods,  i.e.  by  both  drawing  and  remitting. 
For  instance,  A2  makes  out  a  bill  on  E2  ordering  the  latter 
to  pay  Ba.  Ba  sends  it  to  Be  for  collection  (or  discount). 
Ba  thus  gets  a  claim  upon  or  a  credit  with  Be.     Ai  desires 


METHOD  OF  FOREIGN  EXCHANGE  63 

to  remit  a  bank  draft  to  Ei.  He  seeks  of  Ba,  such  a  draft. 
Ba,  having  purchased  A2's  draft  on  E2  and  secured  a 
credit  balance  in  England,  is  able  to  sell  Ai  a  draft  on  Bg 
payable  to  Ei. 

This  is  the  way  in  which,  as  a  matter  of  practice,  most 
of  our  transactions  with  England  are  settled.  When 
Englishmen  owe  us,  we  usually  draw  drafts  upon  them  or 
their  banks,  i.e.  we  draw  upon  London.  We  do  not,  as 
a  rule,  arrange  for  them  to  remit  drafts  on  New  York. 
On  the  other  hand,  if  we  owe  them,  the  understanding 
commonly  is  that  we  shall  purchase  drafts  on  London  and 
remit.  American  banks,  then,  buy  drafts  on  London 
from  those  Americans  having  English  debtors,  send  these 
drafts  to  their  London  correspondents,  and,  on  the 
balances  in  London  so  secured,  sell  drafts  on  their 
London  correspondents  to  Americans  having  English 
creditors.  The  opposite  operations  are  indeed  carried  on, 
but  they  are  much  less  common.  In  general,  it  may  be 
said  that  other  countries  draw  drafts  on  England  in 
much  larger  volume  than  England  draws  upon  them.^ 

Three-cornered  exchange,  also,  may  involve  chiefly 
bills  on  London.  Thus,  if  Americans  have  exported  cot- 
ton to  England  and  imported  mechanical  instruments 
from  Germany,  while  Germany  has  purchased  cloth  of 
England,  drafts  on  London  may  be  used  in  part  for  all 
three  settlements.  American  exporters  of  cotton  will 
draw  drafts  on  the  English  purchasers.  These  drafts 
may  be  used,  in  part,  by  American  banks,  for  remittances 
to  Germany,  as  a  basis  for  the  sale  of  bank  drafts  to 
American  importers  who  must  remit  to  Germany. 
German  banks  will,  in  turn,  send  these  drafts  on  the 

^  Clare,  The  A. B.C.  of  the  Foreign  Exchanges,  London  (Macmillan),  1893, 
p.  12. 


64    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

English  importers  of  cotton  to  England,  in  order  to 
maintain  balances  there  for  the  sale  of  drafts  to  remit- 
ting German  importers  of  cloth. 

London  is,  in  fact,  the  world's  greatest  financial  centre. 
Partly,  perhaps,  because  banking  is  most  fully  developed 
in  England,  partly  because  of  the  magnitude  of  England's 
foreign  trade  and  the  fact  that  payments  have  to  be  made 
to  EngUsh  exporters  by  merchants  of  all  other  countries, 
drafts  on  London  are  nearly  everywhere  in  demand. 
Sellers  of  goods,  in  most  parts  of  the  world,  usually  prefer 
to  take  advantage  of  this  fact  and  realize  on  their  sales 
at  once.  On  the  other  hand,  English  exporters  more 
usually,  though  not  always,  wait  for  remittances  from 
foreign  purchasers  of  their  goods.  The  loss  of  time 
necessarily  incident  to  exchange  transactions  falls,  then, 
except  as  it  is  allowed  for  in  higher  prices  of  goods  sold, 
more  largely  on  English  manufacturers  and  merchants 
and  less  largely  on  other  countries. 

Coming  back  to  the  consideration  of  trade  between 
England  and  the  United  States,  we  may  conclude  that 
drafts  drawn  by  American  business  houses  on  EngHsh 
business  houses  (or  upon  banks  properly  designate^  by 
the  latter),  and  drafts  drawn  by  American  banks  upon 
English  banks,  are  both  part  of  the  supply,  in  the  United 
States,  of  bills  on  England.  The  demand  for  such 
bills  has  also  a  twofold  source.  It  comes,  first,  from 
those  persons  and  firms  other  than  banks,  who  have  obli- 
gations to  meet  in  England  which  they  wish  to  meet  by 
remitting  bank  drafts.  Second,  the  demand  comes  from 
banks  which  may  desire  bills  of  exchange  on  England 
for  either  or  both  of  two  purposes :  in  order  to  maintain 
accounts  in  England,  against  which  they  may  sell  bank 
drafts;    and,  though  less  frequently,  in  order  to  remit 


METHOD  OF  FOREIGN  EXCHANGE  65 

funds  to  English  banks  which  are  sending  to  them,  for 
collection  and  settlement,  drafts  on  American  business 
men.  As  there  is,  in  the  United  States,  both  supply  of 
and  demand  for  exchange  on  England,  so  there  is,  in 
England,  both  supply  of  and  demand  for  exchange  on  the 
United  States.  The  case  is  similar  in  our  commercial 
relations  with  other  countries,  and  in  the  relations  of 
different  parts  of  the  United  States  itself,  to  each  other. 

§6 
How  Exchange  Banks  Make  Profits 

A  market  may  be  defined  as  the  coming  together  of 
buyers  and  sellers.  It  therefore  involves  all  the  mecha- 
nism necessary  to  faciHtate  their  intercourse.  One  may 
speak  of  a  general  market  or  of  a  local  market,  of  a  market 
in  one  or  in  another  place.  Thus,  there  is  the  New  York 
market  for  the  buying  and  selHng  of  exchange  on  London. 
A  bank  in  New  Haven,  Conn.,  may  be  a  part  of  that  mar- 
ket if  it  buys  from  and  sells  to  it.  That  market  includes, 
besides  the  commercial  and  industrial  organizations 
whicK  buy  or  sell  drafts,  all  middlemen  of  whatever  class 
who  engage  in  the  trade. 

The  middlemen  may  be  divided  roughly  into  three 
classes.^  First  may  be  mentioned  banks  which  do  a  reg- 
ular foreign  exchange  business,  buying  bills  from  those 
who  have  them  to  sell  and  selling  their  own  drafts  on 
foreign  correspondents  to  persons  desiring  to  remit. 
Much  of  this  business  is  done  by  foreign  exchange  banks 
which  carry  on  little  or  no  other  business.  Some  of  it 
is  done  by  ordinary  commercial  banks,  such  as  United 

1  Cf .  Escher,  Elements  of  Foreign  Exchange,  New  York  (The  Bankers  Publish- 
ing Company),  igii,  p.  60. 
7 


66    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

States  National  banks,  in  addition  to  their  other  banking 
business.  Second,  we  may  call  attention  to  those  ex- 
change dealers  whose  principal  business  is  to  buy  com- 
mercial and  bankers'  bills,  and  to  resell  them,  chiefly 
to  banks.  Third  are  the  independent  brokers  who  make 
small  commissions  by  bringing  buyers  and  sellers  to- 
gether. These  do  not  invest  their  own  capital,  do  not, 
that  is,  buy  bills  of  exchange  in  the  market,  but  assist 
those  desiring  to  sell  bills  to  find  buyers,  and  vice  versa. 
The  bankers  and  brokers  engaged  in  the  business  of 
foreign  exchange  make  their  money  from  commissions 
and  by  the  difference  between  what  they  pay  for  exchange 
and  what  they  get  for  it.  Thus,  when  a  bank  sells  its 
own  drafts  drawn  upon  a  correspondent  bank,  it  will 
probably  expect  to  receive  a  better  price  than  it  is  wilHng 
to  pay  for  the  commercial  drafts  it  buys  and  remits.  Its 
credit  is  probably  better  than  the  credit  of  most  mer- 
cantile and  industrial  establishments,  and  its  drafts, 
therefore,  more  to  be  desired.  And  it  will  hardly  care  to 
engage  in  the  business  without  receiving  some  profit  as 
a  reward  or  payment  for  its  services. 

It  might  be  supposed  that  business  men,  e.g.  in  the 
United  States,  desiring  to  remit  to  foreign  creditors, 
would  sometimes  buy,  through  the  intermediation  of 
exchange  brokers,  the  identical  bills  drawn  by  other 
American  merchants  on  their  foreign  debtors,  instead 
of  remitting  by  means  of  bank  drafts.  This,  however, 
while  perfectly  possible,  is  seldom  done  in  practice. 
Perhaps  one  reason  is  that  the  business  man  desiring  to 
remit  has  much  more  confidence  in  the  credit  of  a  bank 
than  in  the  credit  of  any  other  company,  and  hence 
prefers  to  buy  a  claim  on  a  bank  to  use  in  remitting. 
Another  and  a  very  practical  reason  is  that  an  exchange 


<N 


METHOD  OF  FOREIGN  EXCHANGE  67 

bank  can  give  a  draft  enabling  the  debtor  to  pay  the 
exact  sum  owed.  Were  he  to  buy  merchants'  bills,  it 
would  be  difficult,  if  not  impossible,  to  make  out  an  even 
sum,  since  they  would  be  for  various  amounts  dependent 
on  the  requirements  of  previous  transactions.  It  falls, 
therefore,  to  the  lot  of  the  banks  to  buy  up  bills  of 
exchange  or  drafts  of  various  amounts,  and  sell  their  own 
drafts,  in  such  sums  as  are  desired,  against  the  credit 
they  thus  obtain  abroad. 

§7 

Various  Types  of  Drafts 

Bills  of  exchange  run  for  various  lengths  of  time  before 
payment.  Some  of  them  are  sight  drafts,  payable  on 
presentation.  Others,  30-day  bills  and  ''long  bills,'' 
such  as  60-day  and  90-day  bills,  are  payable  only  after 
the  lapse  of  a  definite  period  following  presentation  to  the 
drawee.  Bills  of  exchange,  furthermore,  may  be  drawn 
upon  and  by  persons  of  various  degrees  of  credit.  The 
credit  of  both  drawer  and  drawee  is  important,  since,  as 
in  the  case  of  checks,  if  the  drawee  fails  to  honor  a  bill,  the 
drawer  or  maker  of  the  bill  is  liable  to  the  payee.  Both 
of  these  considerations,  therefore,  namely  the  length 
of  time  a  bill  is  to  run,  and  the  credit  of  the  drawer  and 
drawee,  affect  the  bill's  value. 

Bills  of  exchange  may  be  either  "clean"  bills  or  docu- 
mentary.^ Clean  bills  are  those  which  have  no  attached 
documents  giving  security,  but  depend  for  their  value 
and  salability  solely  on  the  reputations  of  the  drawee 
(who  must  pay  the  bill)  and  the  drawer  (who  is  respon- 
sible to  the  holder  if  the  drawee  fails  to  pay).     A  bank 

^  Escher,  Elements  of  Foreign  Exchange,  pp.  45-52. 


4 


68    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

draft  is  an  example  of  a  clean  bill.  Frequently  a  mer- 
chant's draft  on  another  merchant  is  a  clean  bill,  but 
this  is  not  so  universally  the  case. 

Very  usually  a  merchant's  or  manufacturer's  draft 
is  documentary,  i.e.  has  documents  attached.  Suppose 
A2  ships  £1000  worth  of  merchandise  to  E2.  He  may 
then  draw  a  bill  on  E2  ordering  the  latter  to  pay  £1000 
to  Ba.  Before  doing  this,  however,  or  at  any  rate  before 
disposing  of  the  draft,  A2  will  get  from  the  transportation 
company  by  which  the  goods  are  shipped,  a  bill  of  lading 
for  the  goods.  He  will  also,  probably,  insure  the  goods 
against  shipwreck  or  other  loss  or  damage  in  transit. 
The  bill  of  lading  certifies  the  claim  of  A2,  the  shipper, 
upon  the  transportation  company,  to  have  the  goods 
delivered  to  the  consignee.  The  consignee  eventually 
secures  the  goods  by  presenting  the  bill  of  lading  to  the 
transportation  company.  Likewise,  the  certificate  of  in- 
surance certifies  A2's  claim  upon  an  insurance  company, 
in  case  of  damage  or  loss.  A2,  having  made  out  the  draft 
on  E2,  will  attach  to  this  draft  the  bill  of  lading  and  the 
insurance  certificate,  before  disposing  of  it  to  any  bank. 
Possession  of  these  documents  is  then  some  protection  to 
the  bank  in  case  payment  is  refused.  If  neither  the 
drawee  nor  the  maker  of  the  draft  will  or  can  reimburse 
the  bank,  the  goods  may  be  sold,  because  usually  hy- 
pothecated, and  the  proceeds  appKed  to  that  purpose. 

A  banker,  however,  is  not,  supposedly,  an  expert  in  the 
business  of  selKng  the  goods  in  question,  and  may  not 
be  able  to  realize  the  best  price  for  them  without  going 
to  considerable  expense.  Also,  the  market  may  not 
remain  steady  and  the  goods  may  not  for  that  reason 
sell  for  enough  to  cover  the  bank's  advance.  The  busi- 
ness reputation  and  the  financial  standing  of  the  maker 


METHOD  OF  FOREIGN  EXCHANGE  69 

and  of  the  drawee  are  therefore  almost  always  of  impor- 
tance in  determining  the  value  of  a  draft.  If  their  credit 
is  not  established,  the  maker  or  drawer  cannot  hope  to 
receive  quite  as  large  an  amount  for  his  bill  as  otherwise 
he  might. 

Documentary  commercial  drafts,  other  than  sight 
drafts,  may  be  ''acceptance  bills"  or  they  may  be  "pay- 
ment bills."  Acceptance  is  a  formal  acknowledgment 
of  obligation  by  the  drawee.  When  a  draft  is  presented 
to  him  for  acceptance,  he  writes  the  word  "accepted" 
and  his  signature,  across  its  face.  Where,  as  in  England, 
''bank  acceptances"  are  commonly  used,  a  merchant's 
bank  may  undertake  to  "accept"  drafts  for  him  and  so 
becomes  the  drawee.  When  an  acceptance  bill  is  drawn, 
the  drawee  has  sufficiently  good  credit  so  that  his 
acceptance  of  the  draft  gives  him  possession  of  the  bill 
of  lading  and  therefore  of  the  merchandise ;  though  the 
draft  may  be  for  90  or  1 20  days  after  sight,  during  which 
length  of  time  the  drawee  is  not  called  upon  for  payment. 
In  the  case  of  the  payment  bill,  the  drawee's  credit  is 
less  good.  Though  acknowledgment  in  the  form  of 
acceptance  will  be  asked  for,  he  cannot  obtain  the 
merchandise  consigned  to  him  by  merely  accepting  the 
bill  of  exchange,  but  must  actually  pay  it.^  If,  however, 
a  30-day,  90-day  or  other  payment  bill  is  paid  by  the 
drawee  before  maturity,  he  is  allowed  a  rebate  or  dis- 
count from  the  face  of  the  bill. 

In  the  case  of  perishable  goods,  e.g.  produce,  payment 
cannot  be  allowed  by  the  purchaser  to  run,  lest  the  prod- 
uce spoil.     He  pays  the  draft  at  once,  therefore,  under 


^  Escher,  Elements  of  Foreign  Exchange,  p.  49.  When  documentary  drafts 
are  made  payable  a  very  few  days  after  sight,  the  documents  are  apt  to  be  de- 
livered only  upon  payment.    Ibid.,  p.  52. 


70    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

the  rebate  of  interest  arrangement.^  But  this  rebate  will 
be  less  than  the  market  rate  of  discount  on  the  draft.  For 
it  is  not  to  be  expected  that  an  exchange  banker  should 
pay  a  high  price  for  a  draft,  only  to  receive  from  the 
drawee  less  than  he  paid  the  maker.  The  banker  is 
likely  to  safeguard  himself  against  such  a  contingency  by 
paying  for  the  draft  as  little  as  the  least  he  can  expect 
to  receive.  Looking  at  the  matter  from  another  point 
of  view,  we  may  say  that  the  allowance  made  for  payment 
before  maturity  is  not  likely  to  be  so  large  as  seriously 
to  affect  the  value  of  the  draft  to  the  maker  or  seller. 

Documentary  payment  bills  sent  to  England  by  Amer- 
ican banks  for  collection  cannot,  in  general,  be  discounted. 
The  principal  reason  for  this  is  that  such  a  bill  is  payable 
at  the  option  of  the  drawee  on  any  date  prior  to  maturity. 
If  the  goods  are  not  perishable  and  the  drawee  does  not 
immediately  require  them,  they  may  be  warehoused 
until  he  desires  them.  When  this  time  comes,  he 
obtains  the  bill  of  lading  by  making  payment  on  the 
draft.  It  is  convenient,  therefore,  that  the  draft  should 
remain,  until  payment,  with  the  banker  who  originally 
presented  it  for  acceptance,  in  order  that  the  drawee  may 
know  where  payment  should  be  made,  when  he  desires 
to  acquire  possession  of  the  merchandise.^  On  the  other 
hand,  acceptance  bills  drawn  on  English  merchants  or 
English  banks  are  usually  sold  at  a  discount  in  the  Lon- 
don discount  market  by  order  of  the  American  bank 
which  remits  them. 

^Escher,  Elements  of  Foreign  Exchange,  p.  49. 

2  Margraff,  International  Exchange,  Chicago  (Fergus  Printing  Co.),  1903, 
p.  115.  German  banks  themselves  discount  payment  bills  remitted  to  them, 
though  at  a  rate  of  discount  higher  than  the  market  rate,  while  English  banks 
do  not.    See  Margraff,  p.  135. 


METHOD  OF  FOREIGN  EXCHANGE  71 

§8 

The  Sale  of  Demand  Drafts  against  Remittances  of  Long 

Bills 

After  what  has  been  said  regarding  the  discount  of 
bills  of  exchange,  the  reader  will  easily  see  how  banks  can 
sell  their  own  demand  drafts  against  remittances  of  so- 
called  long  bills,  i.e.  bills  of  60  days,  90  days,  etc.  An 
American  bank,  Ba,  can  find  out  by  cable  at  what  rate 
bills  ''to  arrive"  in  London  on  a  certain  date  or  by  a 
certain  steamer  will  be  discounted.  Ba  thereupon  buys 
the  bills  here  of  persons  having  debtors  abroad,  or  of 
other  bankers  or  exchange  dealers.  It  sends  these  bills 
to  its  London  correspondent,  say  Be,  with  orders  for 
immediate  discount,  i.e.  sale.  The  sum  reahzed  con- 
stitutes a  balance  abroad  to  the  credit  of  the  American 
bank,  a  balance  upon  which  it  then  sells  its  own  demand 
drafts  ^  to  Americans  wishing  to  make  remittances.  A 
demand  draft  is  sometimes  sent  by  telegraph  and  is 
then  called  a  ''cable."  ^  It  should  be  noted  that  Ba  has 
a  balance  abroad  long  before  the  bills  sent  abroad  by  it 
for  credit  have  matured,  since  these  bills  it  has  ordered 
sold  in  the  London  discount  market,  and  they  have  got 
into  the  possession  of  persons  or  houses  which  buy  such 
bills  as  investments.  In  the  United  States  there  is  no 
such  discount  market.  Drafts  made  out  in  England  on 
American  debtors,  after  being  purchased  by  English 
banks,  are  forwarded  to  American  correspondent  banks 
for  collection,  but  are  generally  held,  after  "acceptance," 
for  account  of  the  forwarding  English  banks,  until 
maturity,  instead  of  being  sold. 

1  Escher,  Elements  of  Foreign  Exchange,  p.  79. 
^Ibid.,  p.  71. 


72     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

It  follows  that,  as  a  rule,  the  real  creditor  of  an  English 
firm  on  which  an  American  has  drawn  a  6o-day  or  90-day 
draft  is  not  the  American,  for  he  has  had  the  draft  dis- 
counted and  has  received  cash  or  credit.  Nor  is  it  the 
American  bank,  which  has  had  the  draft  sold  in  the 
London  market  and  received  a  credit  balance  with  its 
correspondent  or  has  thereby  Kquidated  a  debt.  It  is 
rather  the  purchaser  of  that  draft,  in  London,  who  must 
wait  (unless  he  resells  it)  60  or  90  days  until  it  matures 
and  he  can  collect  from  the  debtor  firm  in  England. 
Or  we  may  go  one  step  farther  back  and  assert  that  the 
ultimate  creditors  are  depositors  (holders  of  rights  to 
draw)  in  that  English  bank  which  buys  the  draft  in 
question,  or  from  which  the  buyer  of  the  draft  borrowed 
the  means  to  buy  it.^  On  the  other  hand,  when  a  draft 
is  made  out  by  an  Enghsh  firm  on  an  American,  payable 
say  60  days  after  sight,  the  English  bank  which  dis- 
counts it  is  the  creditor,  and,  therefore,  ultimately,  its 
depositors  are  the  creditors.  For  the  draft  will  not 
usually  be  purchased  by  an  American  investor,  but  will 
be  held  by  the  correspondent  bank,  for  account  of  the 
English  bank,  until  maturity.  The  original  English 
debtor  has  received  payment,  but  for  the  time  being 
this  payment  has  come  from  other  English  capital  which 
will  only  be  reimbursed  when  the  American  firm  pays. 

As  a  matter  of  usual  practice,  however,  long  drafts  are 
not  drawn  upon  American  debtors.  The  absence  of  a 
discount  (or,  more  properly,  a  rediscount)  market  here 
means  that  importers  have  one  less  avenue  of  credit  open 
to  them.    Were  there  such  a  market,  drafts  drawn  upon 

^  "The  enormous  amount  of  bills  held  by  the  discount  companies  and  bill 
brokers  in  England  is  to  a  very  large  extent  carried  by  them  through  loans  on 
call  from  the  banks."  Paul  M.  Warburg,  The  Discount  System  in  Europe,  Na- 
tional Monetary  Commission,  igio,  p.  i8. 


METHOD  OF  FOREIGN  EXCHANGE  73 

them  could  be  rediscounted  and  held  until  maturity  by 
whatever  bank  or  person  offered  the  best  rate.  Such  a 
bank  (and,  therefore,  ultimately,  its  depositors)  or  person 
would  be  tlie  real  source  of  credit.  It  is  not  easy  to  say 
just  why  we  have  not,  in  the  United  States,  a  rediscount 
market.  Custom  and  prejudice  may  be  largely  to  blame. 
In  general,  bankers  in  the  United  States  have  regarded 
it  as  evidence  of  financial  weakness  for  a  bank  to  attempt 
to  rediscount  the  notes  of  its  customers.  Furthermore, 
the  national  banking  law,  as  interpreted  by  the  courts,  has 
made  it  illegal  for  any  national  bank  to  ''accept,"  for 
account  of  its  customers,  drafts  upon  it.^  In  England, 
banks  continually  accommodate  their  customers  by  thus 
accepting  drafts.  The  customer  is  responsible,  in  each 
case,  to  the  accepting  bank,  and  must  reimburse  the 
latter  before  the  draft  is  due,  but  acceptance  of  the  draft 
insures  it  and  makes  it  salable.  The  Federal  Reserve 
Act  of  1 9 13  specifically  permits  banks  which  become 
members  of  the  system  thus  to  "accept"  drafts  drawn 
upon  them,^  and  it  empowers  the  Federal  reserve  banks 
to  rediscount  the  commercial  paper  of  member  banks. 
The  law  is  intended,  doubtless,  among  other  things,  to 
further  the  development  of  a  rediscount  market. 

§9 

Summary 

Before  taking  up  a  study  of  the  forces  determining  the 
rate  (or  rates)  of  exchange,  let  us  briefly  restate  the  prin- 
cipal conclusions  regarding  exchange,  already  reached. 
First,  taking  up  our  analysis  where  it  was  left  by  the 

1  See  Jacobs,  Bank  Acceptances,  National  Monetary  Commission,  1910, 
pp.  4;  9. 

2  Under  conditions  prescribed  by  the  law. 


74    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

previous  chapter,  we  saw  that  bills  of  exchange  or  drafts 
simply  extend  to  trade  between  widely  separated  dis- 
tricts the  possibiHties  of  successive  debtorship  and 
creditorship  and  of  debt  cancellation,  which  in  circum- 
scribed areas  are  brought  about  through  the  use  of  checks. 
As  in  the  case  of  checks,  banks  are  really  but  inter- 
mediaries through  whom  and  by  whose  arrangements, 
cancellation  takes  place.  A  consideration  of  the  different 
varieties  of  method  in  settling  obligations  over  long  dis- 
tances served  to  reenforce  the  general  conclusion.  These 
obHgations  are  usually  settled  in  either  of  two  ways : 
first,  the  creditor  may  draw  a  draft  upon  his  debtor 
payable  to  the  creditor's  bank  or  to  some  other  desig- 
nated party ;  second,  the  debtor  may  purchase  a  bank 
draft  with  which  to  remit  to  his  creditor.  Assuming,  in 
trade  between  England  and  the  United  States,  either  of 
these  methods  to  be  used  from  both  sides,  or  assuming 
one  method  from  one  side  of  the  water  and  another  from 
the  other  side,  we  reach  alike  the  same  result.  The  use 
of  drafts  and  the  intermediation  of  banks  make  possible 
an  international  network  of  credit  relations  which  could 
not  otherwise  exist.  The  usual  practice  is  for  American 
creditors  to  draw  on  their  EngUsh  debtors  and  for  Ameri- 
can debtors  to  remit  to  their  EngHsh  creditors. 

When  the  various  ways  of  settling  obligations  through 
the  use  of  bills  of  exchange  had  been  set  forth,  we  were 
ready  to  inquire  of  what,  in  any  country,  the  supply  of 
drafts  upon  another  country  is  made  up.  We  found 
it  to  be  composed  of  two  classes  of  drafts :  those  drawn 
by  the  creditors  of  the  first  country  upon  their  debtors 
in  the  second,  offered  for  sale  to  exchange  bankers ;  and 
those  made  out  by  banks  in  the  first  country  upon  their 
correspondent  banks  in  the  second,  sold  to  debtors  in  the 


METHOD  OF  FOREIGN  EXCHANGE  75 

first  country  who  desire  to  make  remittances  to  the 
second.  Demand  for  drafts,  also,  proved  to  have  a  two- 
fold source,  springing,  on  the  one  hand,  from  debtors 
desiring  bank  drafts  for  remittance  and,  on  the  other, 
from  banks  desiring  commercial  or  bank  drafts  to  settle 
with  or  maintain  balances  in,  correspondent  banks. 
Analysis  of  the  relations  involved  made  it  clear  that 
supply  in  one  country  (or  territory)  of  drafts  upon  a 
second,  brings  about  demand  in  the  second  for  drafts  on 
the  first. 

The  exchange  market  was  briefly  described  and  it  was 
shown  how  exchange  dealers  make  a  profit  from  their 
transactions,  being  able  to  buy  exchange  somewhat  more 
cheaply  and  sell  it  at  somewhat  higher  rates,  than  mer- 
chants, manufacturers,  etc.  Next,  bills  of  exchange  were 
classified  as  sight  drafts  and  long  bills,  according  to  the 
time  to  elapse  before  payment,  and  as  documentary  bills 
and  clean  bills,  according  as  documents,  such  as  a  bill 
of  lading,  do  or  do  not  secure  them ;  and  documentary 
bills,  other  than  those  payable  at  sight,  were  in  turn 
subdivided  into  acceptance  bills  and  payment  bills  ac- 
cording to  what  conditions  the  drawee  must  fulfill  to 
secure  goods  consigned  to  him. 

Finally,  the  process  of  selling  demand  drafts  against 
remittances  of  long  bills  was  briefly  described.  It  was 
pointed  out  that  this  can  be  done  by  American  banks 
by  sending  drafts  on  English  firms  to  England  for  dis- 
count; but  that  in  the  absence  of  a  rediscount  market 
here,  the  reciprocal  operation  is  unusual.  Instead,  long 
drafts  on  American  firms,  in  those  relatively  infrequent 
cases  when  they  are  drawn,  are  generally  held  till  ma- 
turity for  account  of  the  remitting  London  banks.  The 
comparatively  large  discounting,  in  England,   of  bills 


76    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

drawn  by  Americans  on  their  English  debtors,  means 
that  the  capital  which  enables  the  j^merfcans  to  get 
immediate  funds,  comes  largely  from  those  other  Eng- 
lishmen or  English  banks,  who  buy  these  bills  in  the 
discount  market,  or  from  the  depositors  of  the  banks 
where  the  funds  for  purchasing  the  drafts  are  secured. 


CHAPTER  IV 
The  Rate  of  Exchange 

§1 

The  Meaning  of  Par  of  Exchange 

Bills  of  exchange  or  drafts  are  certificates  of  property 
rights,  i.e.  they  certify  rights  to  payment  and,  therefore, 
rights  to  enjoy  the  benefits  of  various  amounts  of  wealth. 
These  rights,  Kke  other  property,  are  subjects  of  purchase 
and  sale,  and  have  a  price  in  any  market  where  they  are 
bought  and  sold.  Also,  the  ruling  price,  at  any  time,  of 
drafts,  like  the  price  of  other  goods,  is  fixed  by  supply  and 
demand. 

Exchange  between  countries  may  be  said  to  be  at 
par  when  a  demand  draft  on  either  country  sells  in  the 
other  for  the  equivalent  in  coin  of  its  face  value,  plus 
or  minus  only  the  insignificant  expense  of  banking  ser- 
vice.^ For  instance,  the  mint  par  between  England  and 
the  United  States  is  £i  =  $4.8665.  This  means  that 
the  material  (gold  11/ 12  fine)  in  an  English  pound  ster- 
ling of  full  weight,  is  just  equal  in  value,  supposing  both 
to  be  in  the  same  place,  to  the  material  which  would 
be  contained  in  $4.8665  of  gold  coinage  (9/10  fine)  of 
the  United  States.  Exchange,  therefore,  would  be  at 
par  between  England  and  the  United  States  if  a  demand 
draft  on  London  for  £100  was  worth,  in  New  York, 

^For  a  bank  might  be  purchasing  good  commercial  sight  drafts  for  very 
slightly  less  and  selling  its  own  drafts  for  very  slightly  more. 

77 


78    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

$486.65.  In  domestic  exchange,  say  between  New  York 
and  Chicago,  par  of  exchange  is  $1  =  $1,  for  the  standard 
of  value  is  in  both  places  exactly  the  same. 

The  rate  of  exchange,  however,  may  go  above  or  fall 
below  par.  Sight  or  demand  drafts  for  the  same  amount 
may  realize  different  sums  on  different  dates.  Our 
problem  is  to  explain,  by  a  study  of  supply  and  demand, 
why  the  rate  of  exchange,  e.g.  between  England  and  the 
United  States,  ever  varies  from  par,  and  why  it  is  fluc- 
tuating rather  than  steady. 

The  Supply  of  and  the  Demand  for  Bills  of  Exchange 

At  the  beginning  of  our  discussion  on  the  rate  of  ex- 
change, it  is  important  to  get  clearly  in  mind  the  mean- 
ing, in  this  connection,  of  the  terms  "supply"  and 
"demand."  In  talking  about  other  goods,  e.g.  wheat, 
we  insist  that  "supply"  means  supply  at  a  price,  and 
that  "demand,"  Hkewise,  means  demand  at  a  price. 
Adopting,  here,  an  analogous  sense,  we  may  say  that 
the  supply,  in  the  United  States,  at  a  given  price  or  rate 
and  for  any  given  period,  of  drafts  on  England,  is  the  total 
of  those  drafts  which  sellers  would  part  with,  at  that 
price  or  rate.  The  supply  of  bills  tends  to  increase  as 
the  price  or  rate  rises  and  to  decrease  as  the  rate  falls.^ 
On  the  other  hand,  the  demand,  in  the  United  States, 
at  a  given  price  or  rate  and  during  any  given  period,  for 
drafts  drawn  upon  EngKsh  firms,  is  the  total  of  such 
drafts  which  buyers  of  drafts  stand  ready  to  purchase 
at  that  price.  The  demand  for  drafts  tends  to  rise  as 
the  price  or  rate  falls  and  to  fall  as  the  rate  rises.^    As,  in 

1  See  §§  4,  5  of  this  Chapter  (IV  of  Part  I),  §§  i,  3  of  Ch.  V  (Part  I),  §  9  of 
Ch.  VI  (Part  I).  2  /jjj. 


THE  RATE  OF  EXCHANGE  79 

the  United  States,  we  have  a  supply  of  and  a  demand  for 
bills  of  exchange  on  England,  so,  in  England,  there  is 
a  supply  of  and  a  demand  for  such  bills  on  the  United 
States.  Since  the  rate  of  foreign  exchange  is  fixed  by 
supply  and  demand,  at  the  point,  of  course,  where  supply 
and  demand  are  equal,  we  have  next  to  determine  what 
forces  affect  supply  and  what  forces  affect  demand,  and 
how  these  forces  operate. 

The  supply,  in  this  country,  of  drafts  upon  any  foreign 
country  or  upon  all  foreign  countries  together,  is  deter- 
mined by  obligations,  agreements  or  desire  of  foreigners 
to  make  payments  to  us.^  This  is  obviously  the  case 
with  commercial  drafts  drawn  on  foreign  purchasers  of 
American  goods.  These  drafts  come  into  our  exchange 
market  because  foreign  debtors  are  under  business  obli- 
gations to  the  makers  of  the  drafts.  But  it  is  no  less 
true  of  bank  drafts  drawn  to  accommodate  American 
debtors  wishing  to  remit.  The  bank  draft  is  drawn 
upon  a  foreign  bank  which  is,^  or  which  puts  itself,  un- 
der obligation  to  pay  to  the  American  bank's,  order.  A 
draft  drawn  on  a  foreign  bank  wishing  to  lend  here  for 
profit,  is  determined  by  desire  of  the  foreign  bank  so 
to  invest.  All  drafts,  therefore,  offered  for  sale  in  our 
market,  are  based  on  the  necessity  which  foreigners  are 
under  or  their  desire  to  make  payments  to  some  of  us. 

Conversely,  the  demand  here  for  drafts  on  foreign 
countries,  is  determined  by  our  obligations  to  them  and 
b^  our  occasion  to  make  voluntary  payments  to  them. 
This  demand,  as  we  have  seen,^  has  a  twofold  source. 
It  comes  from  business  houses,  etc.,  which  wish  to  buy 
bank  drafts  for  remitting  to  their  creditors  and  other 

1  See,  however,  paragraph  after  next. 
«  Chapter  III  (of  Part  I),  §§  4,  5. 


8o    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

persons  abroad;  and  it  comes  from  American  banks 
which  wish  to  buy  commercial  drafts  for  remitting  to 
their  correspondents.  These  American  banks  have 
occasion  to  remit,  largely  to  maintain  foreign  balances 
on  which  to  sell  their  own  drafts,  but  partly  because 
EngHsh  firms  have  drawn  upon  American  debtors  and 
settlement  must  be  made  through  American  banks  to 
which  the  drafts  on  Americans  have  been  sent  for  col- 
lection. These  American  banks  will,  therefore,  wish  to 
buy  drafts  on  England  in  order  to  remit.  The  more 
usual  practice,  as  we  have  seen,^  is  for  our  English  credi- 
tors to  await  remittances  by  their  American  debtors, 
in  drafts  on  London. 

So  far  as  foreign  debtors  choose  to  settle  by  remitting 
drafts  on  American  banks,  obligations  from  abroad  to 
us  do  not  increase  the  supply,  here,  of  drafts  on  for- 
eign countries.  But  the  effect  on  the  rate  of  exchange 
is  the  same,  for  our  banks,  by  honoring  these  drafts, 
in  so  far  are  reHeved  from  the  necessity  of  buying  drafts 
on  foreign  countries  to  keep  square  with  their  foreign 
correspondent  banks.  In  other  words,  there  is  a  de- 
crease, here,  of  demand  for  drafts  on  foreign  countries, 
instead  of  an  increase  of  supply.  But  the  rate  of 
exchange  is  affected  in  the  same  way  and  to  the  same 
extent  in  either  case. 

The  supply,  here,  of  drafts  on  foreign  countries,  may 
be  said  to  depend,  chiefly,  on  the  following  sources  of 
obUgation  and  voluntary  payments  from  them  to  us, 
though  some  of  the  obligations  are  more  Hkely  to  be 
settled  by  remittance  and  therefore  to  increase  demand 
abroad  for  drafts  on  the  United  States  and  decrease 
demand  here  for  drafts  on  foreign  countries,  rather  than 

1  Chapter  III  (of  Part  I),  §  5. 


THE  RATE  OF  EXCHANGE  8i 

to  increase  supply  here  of  drafts  on  foreign  countries. 
The  items  in  group  5  are  perhaps  most  likely  to  be  settled 
by  remittances.     Following  are  the  groups : 

1.  Purchase,  abroad,  of  American  merchandise. 

2.  Purchase  by  foreigners,  from  Americans,  of  trans-^ 
portation,  banking,  insurance,  and  other  services. 

3.  Purchase,  abroad,  of  American  securities,  and 
repurchase  or  redemption  of  foreign  securities  held 
here. 

4.  Agreements  by  which  foreigners  make  short  time 
loans  to  Americans,  and  (which  amounts  to  the  same 
thing)  ^  agreements  by  w^hich  our  bankers  may  draw 
finance  bills  on  foreign  banks ;  repayment  of  such  short 
time  borrowing  done  by  foreign  banks  from  American 
banks. 

5.  Payment  of  interest,  dividends,  rent,  etc.,  on 
American  investments  abroad,  remittances  to  Euro- 
peans travelling  in  the  United  States,  etc. 

On  the  other  hand,  the  demand,  here,  for  drafts  on 
foreign  countries,  depends  in  the  main  on  corresponding 
sources  of  obligation  and  voluntary  payments,  as  follows : 

1.  Purchase,  by  Americans,  of  merchandise  from 
foreign  countries. 

2.  Purchase,  by  Americans  from  foreigners,  of  trans- 
portation, banking,  insurance,  and  other  services. 

3.  Purchase,  by  Americans,  of  foreign  securities,  and 
repurchase  or  redemption  of  American  securities. 

4.  To  make  short  time  loans  abroad,  to  repay  short 
time  loans  from  abroad  and  (which  is  fundamentally 
the  same  thing)  to  repay  obligations  incurred  by  Ameri- 
can banks  which  have  drawn  finance  bills  on  foreign 
banks. 

1  See  §§  4,  5  of  this  Chapter  (IV  of  Part  I). 
O 


82    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

5.  Payment  of  interest,  dividends,  rent,  etc.,  to 
foreigners  who  have  invested  money  here,  remittances 
to  Americans  travelling  abroad,  remittances  to  families 
abroad  of  immigrants  living  here,  etc. 

Though  the  Hsts  above  given  correspond,  it  must  not 
be  assumed  that  the  payments  in  one  direction  under 
any  particular  item  are  the  equivalent  of  the  payments 
under  the  same  item  in  the  other  direction.  In  many 
cases  the  difference  is  very  great.  Thus,  practically 
nothing  is  paid  by  foreigners  to  Americans  for  the  trans- 
portation of  goods,  unless  we  include  in  this  item  the 
transportation  in  the  United  States  itself,  of  goods 
eventually  to  be  shipped  abroad.  But  Americans 
pay,  every  year,  millions  of  dollars  to  Englishmen  for 
the  transportation  services  of  Great  Britain's  merchant 
marine.  Similarly,  the  balance  of  payments  for  bank- 
ing services  would  be  against  the  United  States,  since 
London  is  the  principal  banking  center  of  the  world. 
Again,  remittances  by  immigrants  in  the  United  States 
to  their  families  in  Europe  would  not  be  balanced  by 
payments  of  any  similar  nature  made  by  Europeans  to 
people  here.  Contrariwise,  payments  by  Europeans 
to  Americans  for  merchandise  might  be  considerably 
in  excess  of  similarly  caused  payments  in  the  opposite 
direction. 

Since  the  Um'ted  States  is  still,  in  large  part,  an  agri- 
cultural country,  its  exports  tend  to  be  periodic  rather 
than  uniform.  The  largest  exports  from  the  United 
States  are  in  the  fall  after  the  crops  have  been  harvested. 
But  the  things  we  buy  flow  to  us  in  a  more  steady  stream. 
Hence  there  is,  in  the  fall,  a  relatively  large  supply  of 
drafts  on  foreign  countries,  for  sale  in  the  United  States, 
and  a  comparatively  low  price  for  them  or  low  rate  of 


THE  RATE  OF  EXCHANGE  Ss 

exchange.*  Banks  can  then  purchase  these  bills  more 
cheaply  as  a  rule  than  at  other  times,  and  will  therefore 
be  able  to  sell  their  own  demand  drafts  at  lower  rates. 

§3 

The  Effect  on  the  Exchange  Market  of  any  Country 
of  Disturbed  Political  or  Industrial  Conditions  in 
That  Country  and  in  Other  Countries 

Investments  for  long  periods,  nowadays,  take  place 
largely  through  the  purchase  of  stocks  and  bonds, 
though  also  through  the  purchase  of  real  estate,  the 
loaning  to  individuals  on  mortgage  security,  etc.  The 
buyer  of  a  bond  is  a  lender  to  the  government  or  company 
whose  bond  he  buys.  The  buyer  of  stock  has  a  right 
to  residual  gains.  The  entire  western  European  world:. 
is  now  a  possible  market  for  American  securities,  whether 
tlic&&^&ecujitiea-  represent  public  or  corporate  iiadebt? 
edness  or  rights  to  corporate  profits.  To  some  extent, 
the  United  States  furnishes  a  market  for  European 
securities,  but  to  a  far  less  cxt^^t.  Europeans  have,  in 
the  past,  invested  more  here  than  Americans  have  in- 
vested in  Europe.     The  English  people,  for  instance, 

1  The  truth  of  this  statement  is  evidenced  by  statistics  compiled  by  one  of 
my  students,  Mr.  Lawrence  M.  Marks,  Yale  1914,  from  successive  volumes 
of  the  Commercial  and  Financial  Chronicle.  Taking  the  highest  and  lowest 
quotations  for  each  month,  of  exchange  on  London,  and  averaging  all  the  Janu- 
aries,  all  the  Februaries,  etc.,  for  the  years  1906-1910  inclusive,  Mr.  Marks  ar- 
rived at  the  following  results : 

January    4.872  July  4.872 

February  4.875  August       4.8685 

March      4.8725  September  4.866 

April        4-8715  October      4.8665 

May         4-875  November  4.8695 

June         4.876  December  4.869 

Cf.  also  Clare,  The  A.  B.  C.  of  the  Foreign  Exchanges,  London  (Macmillan), 
1893,  pp.  135,  136. 


84    THE  EXCHANGE  MECHANjSM  OF  COMMERCE 

have  been  large  accumulators,  and  so  have  forced  the 
rate  of  interest  in  England  down  to  a  comparatively 
low  level.  Here,  the  rate  of  interest  has  been  higher. 
Consequently,  Englishmen  have  made  large  purchases  of 
American  securities.  And,  to  a  considerable  extent, 
they  still  hold  these  securities,  despite  the  tendency 
during  the  last  few  decades  for  American  industry  to 
be  financed  in  greater  degree  by  American  capital. 

Largely  because  of  foreign  interest  in  American  se-  "^ 
curities,  the  exchange  market  may  sometimes  be  much 
affected  by  American  financial  troubles.  If,  for  a  while, 
prosperity  threatens  to  forsake  us,  many  foreign  holders 
of  our  corporate  securities  may  become  alarmed  and 
endeavor  to  dispose  of  their  holdings  even  at  sacrifice 
quotations.  American  capitalists  may  therefore  be 
induced,  to  some  extent,  to  buy  these  securities  back 
again.  So  far  as  this  effect  is  realized,  there  is  a  ten-  ^ 
dency  for  the  rate  of  exchange  on  other  countries,  i.e, 
the  price  of  drafts  on  these  countries,  to  rise.  For  it 
puts  American  investors  under  obhgation  to  remit  to 
those  from  whom  securities  have  been  purchased;  or, 
if  the  foreign  sellers  have  drawn  drafts  upon  America, 
then  American  banks  must  purchase  drafts  on  foreign 
countries  in  order  to  settle  with  their  correspondents. 
In  either  case,  the  demand,  here,  for  drafts  on  other 
countries  rises. 

If,  on  the  other  hand,  investments  which  Americans 
may  have  in  other  countries,  e.g.  in  Mexico  or  in  certain 
of  the  South  American  republics,  seem  to  be  rendered 
unsafe  because  of  threatened  political  disturbance  or 
open  revolution,  then  the  endeavor  of  Americans  to  dis- 
pose of  such  investments  will  tend  to  increase  the  supply 
of  drafts  on  such  countries  and  so  may  lower  the  rate 
at  which  these  drafts  sell. 


THE  RATE  OF  EXCHANGE  8s 

§4 

Analysis  of  the  Relations  Involved  in,  and  Explanation 
of  the  Results  oj,  Short  Time  i^oans  Made  Ostensibly 
by  Foreign  Banks,  through  the  Intermediation  oj  the 
Exchange  Market 

One  of  the  sources  given  in  our  Ifsts,  of  the  supply  in 
one  country  of  drafts  on  another  or  others,  is  short  time 
''loans"  {e.g.  60  or  90  days)  by  banks.  Some  of  the 
banks  in  one  country  may  choose  to  ''lend"^  in  another 
country.^  Let  us  suppose  that  a  London  bank,  Be, 
wishes  to  ''lend,"  in  the  United  States,  the  sum  of 
$50,000.  It  would  cable  its  New  York  correspondent, 
Ba,  to  draw  on  it  a  draft  payable  in  perhaps  90  days  after 
sight.  This  draft  could  be  sold  in  New  York  to  another 
exchange  dealer  or  banker,  and  the  sum  realized  loaned, 
for  account  of  the  London  bank,  to  an  American  firm 
or  business  man. 

The  loan  made  may  be  a  so-called  "sterling"  (like- 
wise mark  or  franc)  loan,  or  it  may  be  a  "currency" 
loan.^  In  the  case  of  the  sterling  loan,  it  is  agreed  that 
the  foreign  bank  shall  receive  a  definite  commission  or 
payment  from  the  borrower,  for  allowing  him  to  raise 
money  by  a  draft  upon  it.  If  the  loan  is  a  sterlingjoan, 
the  borrower  (the  American  business  Jiouse  p;pttinff -the 
use  of  the  funds)  takes  the  risk  of  fluctuation  in  the  rate 
of  exchange  during  the  life  of  the  loan.  The  American 
bank,  Ba,  draws  a  draft  on  Be  payable  to  the  American 
borrower.  This  draft  is  for  so  many  pounds  sterHng. 
Hence   the   arrangement  is   called   a   "sterling"   loan. 

^  Who  is  the  real  lender  will  appear  later  in  this  section. 
2  See  descriptive  discussion  in  Escher,  Elements  of  Foreign  Exchange,  New  York 
(The  Bankers  Publishing  Co.),  iQn,  pp-  85,  86. 
» im„  p.  87. 


86    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  borrower,  to  whom  the  draft  is  given,  gets  his  money 
or  his  bank  credit  by  disposing  of  the  draft  at  the  best 
price  he  can  get.  When  the  90  days  are  up,  it  devolves 
upon  him  to  purchase  a  demand  draft,  payable  to  the 
lending  bank.  Be,  and  turn  it  over  to  Ba  for  remittance. 
The  lending  bank  must  honor,  at  the  end  of  the  90  days, 
the  draft  drawn  on  it  by  Ba,  for  this  will  have  reached 
London,  and  payment  will  be  due  90  days  after  pres- 
entation. But  Be  will  by  that  time  have  received  the 
bank  draft  purchased  by  the  borrower,  and  so  will  be 
able  to  pay  without  any  drain  on  its  resources.  It  has 
gone  through  the  form  of  lending  while  not  parting  with 
a  single  pound.  It  has  only  taken  upon  itself  the  obK- 
gation  to  pay,  90  days  after  sight,  a  sum  which  it  was 
practically  certain  to  receive  (although  there  was,  of 
course,  some  risk)  equally  soon  from  the  American 
borrower. 

The  "  currency '^  loan  is  different  only  in  the  formal 
arrangements.  It  serves  the  same  purpose.  Ba  does 
not,  in  this  case,  hand  over  the  draft  on  Be,  for  the  bor- 
rower to  sell,  but  itself  sells  the  draft  to  another  bank 
or  dealer.  It  then  gives  the  borrower  cash  or  credit 
in  terms  of  American  currency.  That  is  why  it  is  called 
a  currency  loan.  The  borrower  gets  dollars,  not  a 
claim  to  pounds  sterling  requiring  to  be  converted  into 
dollars.  When  the  time  comes  for  repayment,  the  bor- 
rower settles  with  Ba  and  Ba  settles  with  Be.  The  bor- 
rower pays  an  agreed  rate  of  interest.  The  lending 
bank,  Bg,  is  subject  to  a  risk  of  fluctuation  in  the  rate 
of  exchange.  If  this  bank  foresees  a  probabiHty  that 
exchange  will  fluctuate  favorably  to  it,  then  it  will  prefer 
to  make  the  currency  loan ;  if  unfavorably,  it  will  prefer 
to  make  the  sterling  loan. 


THE  RATE  OF  EXCHANGE  87 

We  have  seen  that  the  so-called  lending  bank,  Be, 
is  at  no  time  out  actual  funds  by  virtue  of  its  transac- 
tion. It  lends  only  in  name.  Yet  the  American  bor- 
rower gets  funds  in  the  form  of  cash  or  bank  account, 
and  eventually  buys  goods  with  these  funds.  Some- 
where there  is  a  real  lender,  an  ultimate  creditor.  Who 
and  where  is  he  ?  The  answer  is  :  he  is  the  man  or  firm 
who  buys  the  draft  when  it  is  offered  for  sale  in  the 
London  discount  market,  or  the  depositors  of  the  bank 
from  which  this  man  or  firm  borrowed  the  means  to 
buy.  For  the  draft  on  Be,  having  been  sold  in  the  United 
States  to  an  exchange  dealer  or  bank,  would  be  sent  by 
the  American  bank  to  its  correspondent  bank  in  London, 
and  by  the  latter  sold  to  whoever  cared  to  invest  in  it. 
This  Enghsh  investor  it  is,  or  the  depositors  of  a  bank 
from  which  he  borrows,  who  gives  up  early  income  for 
later.  He  (or  they)  is  giving  up  present  goods  for  future 
goods.  He  is  the  one,  or  these  depositors  are  the  ones, 
because  of  whose  accumulations  the  whole  transaction 
is  possible.  The  American  business  man  borrower 
gets,  if  not  cash,  a  bank  account,  just  as  if  he  borrowed 
it  from  Ba,  and  with  this  bank  account  he  buys  goods. 
But  instead  of  being  indebted  to  Ba  and  through  Ba  to 
its  depositors,^  he  is  indebted,  in  the  case  of  the  sterling 
loan,  to  Be,  through  Be  to  the  English  purchaser  of  the 
draft,  and  through  him  to  the  depositors  in  any  bank 
from  which  he  gets  the  means  to  purchase ;  in  the  case 
of  the  currency  loan,  to  Ba,  through  Ba  to  Be,  through 
Be  to  the  English  purchasers  of  the  draft,  and  finally 
to  depositors  in  this  purchaser's  bank.  The  English 
bank  is  but  a  nominal  lender.  The  EngHsh  (or  other) 
purchaser  of  the  draft  in  the  London  discount  market, 

1  See  Ch.  II  (of  Part  I),  §  3. 


88    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

and,  in  the  last  analysis,  the  depositors  in  his  bank,  are 
the  real  lenders.  In  Chapter  II  we  saw  that  commercial 
banking  combines  and  coordinates  sporadic  convenience 
waiting  so  as  to  make  available  to  borrowers  in  the  form 
of  loans,  a  considerable  amount  of  this  waiting,  waiting 
which  would  in  any  case  be  done  because  of  convenience, 
and  which,  except  for  commercial  banking,  would  be 
of  no  use  to  borrowers.  Here  we  see  that  the  sporadic 
waiting  done  by  bank  depositors  in  one  country,  may 
be  the  means  of  providing  borrowers  in  another  country, 
with  funds.  As  is  to  be  expected,  the  waiting  or  ultimate 
lending,  in  the  case  of  these  drafts,  is  done  more  largely 
abroad,  and  the  borrowing  so  made  possible  is  done  more 
largely  by  Americans. 

Foreign  loans  of  the  kinds  we  have  been  describing, 
i.e.  sterling  and  currency  loans,  may,  if  most  largely 
made  in  the  spring  and  early  summer,  help  to  tide  over 
the  periods  of  the  year  when  the  United  States  has  a 
surplus  of  payments  to  make  abroad,  so  that  these 
payments  need  not  be  so  large.  Instead  of  our  sending 
large  amounts  of  specie  abroad,  English  purchasers,  in 
the  London  discount  market,  of  drafts  drawn  upon 
"lending"  London  banks,  and,  through  these  purchasers, 
depositors  in  English  banks,  may  become  temporarily 
our  creditors.  They  lend  to  us  by  providing,  for  a  time, 
the  capital  to  liquidate  obKgations  from  us  to  English 
manufacturers  and  merchants,  obligations  for  which, 
if  we  could  not  get  temporary  credit,  specie  would  have 
to  flow.  Then  when  the  crop  season  comes  and  the 
pressure  of  obligations  is  more  markedly  the  other  way, 
we  pay  the  holders  of  these  drafts  by  transferring  to 
them  part  of  our  claims  upon  purchasers  of  our  exports. 
Instead  of  money  flowing,  first  from  here  to  England,  for 


THE  RATE  OF  EXCHANGE  89 

example,  and  then,  in  the  fall,  from  England  back  to  us, 
less  will  have  gone  either  way.^  During  the  winter, 
spring,  and  early  summer,  our  net  indebtedness  abroad 
would  perhaps  have  required  considerable  gold  ship- 
ments. But  any  drafts  drawn  during  this  period  upon 
English  banks,  nominally  lending  banks,  are  available 
for  purchase  by  American  exchange  bankers  who  must 
make  remittances  abroad.  The  shipment  of  gold  abroad 
is  thus  avoided.  Then  in  the  fall  when  we  are  selling 
considerable  amounts  of  grain  and  other  products  and 
drafts  on  England  are  low  in  price,  and  when  large  im-. 
ports  of  gold  might  result,  in  payment  for  our  exports 
of  wheat,  cotton,  etc.,  these  imports  of  gold  are  made 
less  by  the  fact  that  those  Americans  who  have  received 
the  temporary  loans  (or,  in  the  case  of  currency  loans, 
the  banks  which  act  for  them)  have  now  to  liquidate 
their  obKgations  by  purchasing  drafts  on  London. 

The  comparatively  high  rates  of  exchange  on  lEngland 
during  the  seasons  when  we  are  exporting  less  than  we 
are  importing,  and  the  comparatively  low  rates  in  the 
fall,  tend  to  make  these  dealings  worth  while.  Those 
who  thus  borrow  during  our  surplus  importing  season, 
e.g.  late  spring  or  early  summer,  sell  their  drafts  at  a 
relatively  high  price  and  buy  later  for  remitting,  if  in 
the  fall,  at  a  lower  price.  The  London  bank  which 
engages  in  the  operation  will  intend  to  receive  its  share 
of  the  gain  resulting  from  this  situation;  at  least  in 
the  case  of  the  currency  loan,  as  we  have  seen,  ^  it  clearly 
gets  the  benefit  of  a  favorable  movement  in  the  rate  of 
exchange  on  London;    and  we  should  therefore  expect 

1  Cf.  Goschen,  The  Theory  of  the  Foreign  Exchanges,  third  edition,  London 
(EflBngham  Wilson),  1896,  pp.  38-41. 

2  See  description  at  beginning  of  this  section. 


90    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

it,  other  things  equal,  to  engage  most  gladly  in  the  lend- 
ing operation  described,  at  the  very  times  when  its 
doing  so  would  avoid,  or  decrease  in  amount,  successive 
and  opposite  shipments  of  gold. 

§s 

Finance  Bills,  What  they  Are,  Whose  Accumulations  Make 
them  Possible  and  What  are  their  Results 

The  case  of  a  finance  bill  ^  is  not  greatly  different  from 
that  of  a  bill  drawn  on  a  foreign  bank  which  expresses 
a  desire  to  lend.  There  is,  indeed,  a  difference,  but  it 
is  superficial  rather  than  fundamental.  In  the  case  of 
the  bill  drawn  on  a  foreign  lending  bank,  the  foreign 
bank  is  lending  as  an  investment  for  its  own  profit. 
In  the  case  of  the  finance  bill,  the  drawing  is  done  for 
the  convenience  and  profit  of  the  drawing  bank,  in  our 
illustration  the  American  bank.  In  this  case,  the  Eng- 
lish bank  does  not  request  the  American  bank  to  draw 
on  it  to  the  end  that  the  English  bank  can  profit  by  so- 
called  lending.  On  the  contrary,  the  American  bank 
gets  the  permission  of  the  English  bank  to  draw  a  draft 
on  the  latter.  For  in  the  case  of  the  finance  bill  the  Eng- 
lish bank  is  under  no  obUgation  to  the  American  bank. 
The  latter,  therefore,  has  no  right  to  draw  a  draft  on  the 
former  except  by  permission.  Arrangement  is  accord- 
ingly made  between  the  banks.  The  American  bank, 
Ba,  is  given  the  right  to  draw  on  the  EngHsh  bank.  Be, 
in  return  for  a  fee  or  commission.  Ba  then  draws  on 
Be,  sells  the  draft  in  the  market,  and,  for  the  time  being, 
e.g.  90  days,  has  the  use  of  so  much  extra  currency. 

1  Escher,  Elements  of  Foreign  Exchange,  pp.  94-98,  gives  a  brief  description 
of  the  finance  bill. 


THE  RATE  OF  EXCHANGE  91 

Ba's  credit  is  good  enough  so  that  Be  is  willing  to  "accept " 
the  draft  or  drafts,  in  confidence  that  when  the  90  days 
after  sight  are  up,  and  payment  is  demanded,  it  will 
already  have  received  remittance  from  Ba-  It  will  at 
no  time  be  out  any  money.  The  finance  bill  is  therefore 
not  greatly  unlike  the  class  of  bills  previously  described, 
drawn  on  foreign  lending  banks. 

As  in  the  case  of  the  lending  operation,  so  in  the  case 
of  the  finance  bill  above  discussed,  some  American  (or 
Americans),  is  borrowing  from  abroad.  In  the  case 
of  the  finance  bill,  the  borrower  is  the  American  bank 
which  gets  the  90-day  control  of  currency,  and,  through 
the  bank,  any  person  or  persons  who  are  thus  enabled 
to  borrow  from  it.  Here,  as  before,  the  real  lender  is 
the  person,  or  firm,  in  England,  who  purchases  the  draft 
in  London,  whither  it  has  been  sent  for  sale  in  the  dis- 
count market,  and  through  him  the  depositors  in  the 
Enghsh  bank  or  banks,  whose  convenience  waiting  gave 
him  the  means  to  invest  in  the  draft.  Ba  owes  Bg,  but  Bg 
owes  this  holder  of  its  draft,  and  he,  in  turn,  is  indebted, 
through  a  bank  as  intermediary,  to  the  depositors  of 
that  bank,  whose  convenience  waiting  provided  him 
with  the  means  of  purchase. 

Like  the  short-term  loan  operation,  the  finance  bill  — 
also  really  a  loan  from  abroad  —  may  serve  to  tide  over 
a  period  of  surplus  imports,  so  that  gold  need  not  so 
largely  be  shipped  out  at  one  season  of  the  year  only 
to  be  shipped  back  again  in  a  couple  of  months.  If, 
in  the  spring  and  early  summer,  when  we  are  perhaps 
importing  largely  and  exporting  less,  and  have,  there- 
fore, a  surplus  indebtedness,  our  banks  are  allowed  to 
draw  finance  bills,  these  drafts  come  into  the  market 
and  are  available  for  use  in  paying  off  part  of  the  balance 


92    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  obligations.  We  therefore  pay  previous  obligations 
by  making  new  ones.  Considered  as  a  nation,  we  post- 
pone payment;  for  what  one  group  of  persons  pays, 
another  group  has  borrowed.  Then,  in  the  fall,  when 
there  would  otherwise  be  a  balance  of  obHgations  from 
others  to  us,  this  balance  is  diminished  by  our  postponed 
obligations  to  them.  Not  only,  then,  are  there  smaller 
shipments  of  gold  abroad  in  the  earlier  period,  but  also 
there  are  smaller  return  shipments  at  the  later.^ 

It  needs,  however,  to  be  demonstrated  that  finance 
bills  will  most  probably  be  drawn  by  American  banks 
at  those  times  when  we  have  a  balance  of  obligations  to 
meet,  thus  relieving  the  pressure,  and  serving,  as  above 
suggested,  to  obviate  the  necessity  of  gold  shipments. 
The  theory  of  individualism,  as  distinguished  from  so- 
cialism, is,  that  in  serving  their  own  interest,  men  are, 
in  their  economic  activities  (except  where  certain  un- 
fair methods  of  business  are  improperly  permitted,  or 
certain  classes  of  wealth  or  income  not  really  earned  are 
unwisely  secured  to  individuals),  serving  the  public 
interest.  Let  us  see  how  the  individualistic  philosophy 
applies  in  this  case.  In  that  part  of  the  year  when  the 
United  States  owes  largely,  the  price  in  the  United 
States  of  exchange  on  foreign  countries,  is  high.  It 
pays  Ba,  therefore,  to  draw  finance  bills,  and  sell  them 
at  this  high  price.^  On  the  other  hand,  the  excess  of 
obligations  towards  us  in  the  fall,  and  the  consequent 
excess  of  drafts  on  foreign  debtors,  for  sale  here,  makes 
the  price  of  these  drafts  at  that  time  low.  Ba  can  there- 
fore buy  drafts  to  repay,  at  a  low  price.     If  necessary, 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  38-41 ',  also  Bastable, 
The  Theory  of  International  Trade,  fourth  edition,  London  (Macmillan),  1903,  p.  78. 
*  Or  itself  forward  them  for  discount  and  credit  abroad. 


THE  RATE  OF  EXCHANGE  93 

the  loan  can  be  renewed  by  the  drawing  of  a  new  draft 
to  replace  the  old,  in  cases  where  it  is  some  time  before 
the  rate  falls.  Ba  therefore  proiits,  besides  the  interest 
which  can  be  earned  during  the  time  it  can  invest  or 
loan  the  amount,  by  the  difference  between  the  price 
of  the  drafts  at  one  time  and  another,  minus,  of  course, 
Be's  commission.  Such  drafts  are,  therefore,  other 
things  being  equal,  most  likely  to  be  drawn  by  profit- 
seeking  banks  at  the  very  times  when  they  will  serve 
the  purpose  of  avoiding  gold  shipments.^ 

§6 

How  a  Bank  in  One  Country  and  a  Bank  in  Another  May^ 
through  the  Aid  of  the  Exchange  Market,  Invest  in 
One  oj  the  Countries  for  Joint  Account,  without  Either 
Bank  Using  its  Own  Funds 

Another  variety  of  this  species  of  draft  is  that  some- 
times drawn  when  an  American  and  a  foreign  bank  in- 
vest here  on  joint  account.^  Ba  may  see  that  it  can  pur- 
chase certain  securities  cheaply  at  the  time,  securities 
which  can  probably  be  sold,  later,  at  a  substantial 
profit.  But  Ba  has  use  for  all  the  funds  under  its  own 
immediate  control,  and  does  not  wish  to  invest  any  of 
these  funds  in  such  securities.  It  suggests,  therefore, 
to  its  English  correspondent.  Be,  that  both  go  into  this 
investment,  on  joint  account,  securing  the  means  through 
the  use  of  exchange.  Ba  then  draws  on  Bg  a  draft  matur- 
ing in  say  90  days  after  sight,  which  is  sold  in  New  York. 
With  the  proceeds  the  securities  are  purchased  and  held 

^  Cf.  Clare,  The  A. B.C.  of  the  Foreign  Exchanges,  1893,  p.  86;  also  Escher, 
Elements  of  Foreign  Exchange,  p.  97,  and  Margraff,  International  Exchange^ 
Chicago  (The  Fergus  Printing  Co.),  1903,  p.  39. 

2  Process  described  in  Escher,  Elements  of  Foreign  Exchange,  pp.  133-135. 


94    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

for  90  days  or  perhaps  a  less  period.  They  are  then  sold, 
presumably  at  a  profit,  and  remittance  is  made  to  Be. 
The  draft  on  Be  was  purchased  in  New  York,  sent  to 
London,  and  sold  in  the  London  discount  market.  By 
the  time  the  purchaser  presents  it  to  Bg  for  payment, 
Ba  has  remitted.  Neither  bank  has  sacrificed  the  use 
of  its  own  funds.  As  in  the  other  cases,  the  capital  is 
really  furnished,  in  the  last  analysis,  by  the  purchaser, 
in  the  London  discount  market,  who  has  bought  the 
draft,  or,  in  all  probability,  by  the  depositors  of  a  bank 
from  which  the  purchaser  borrowed  the  means  to  make 
the  investment.  Thus  it  is  that  an  American  and  an 
English  bank  can  invest  here,  for  joint  account,  in  securi- 
ties, without  either  of  them  providing  the  means.  The 
capital  is  really  put  up  by  an  EngHshman  or  Englishmen, 
but  not  by  the  English  bank  on  which  the  bill  is  drawn. 
As  in  the  case  of  lending  by  a  foreign  bank  and  the  case 
of  the  finance  bill,  so  here,  there  would  be  some  addi- 
tional stimulus,  other  things  equal,  to  the  drawing  of 
such  drafts  on  foreign  banks  at  those  times  of  the  year 
when  drawing  them  would  decrease  the  shipments  of 
gold. 

§7 

Analysis  of  the  Relations  Involved  in  a  Letter  of  Credit 

The  exportation  and  the  importation  of  goods  may 
often  be  greatly  facilitated  by  so-called  letters  of  credit.^ 
These  letters  of  credit  make  possible  the  drawing  of 
bills  of  exchange  on  other  parties  than  the  actual  debtors, 
and  at  times  such  an  arrangement  is  very  helpful.  As 
above  suggested,  this  form  of  commercial  credit  may  be 
used  to  further  either  import  or  export  trade.     Since 

1  Described  by  Escher,  Elements  of  Foreign  Exchange,  pp.  143-160. 


THE  RATE  OF  EXCHANGE  95 

it  will  facilitate  importation  and  since  exportation  by  us 
is  importation  by  some  other  country,  it  must  facilitate 
exportation  also. 

The  use  of  a  letter  of  credit  is  as  follows.  A  man 
importing  goods,  say  from  South  Africa  into  the  United 
States,  desires  to  get  possession  of  them  at  once,  but  is 
not  in  a  position  to  pay  for  them  until  he  can  himself 
dispose  of  them  for  currency.  He  cannot,  therefore, 
pay  for  them  by  remitting  a  bank  draft.  On  the  other 
hand,  the  South  African  exporter  desires  to  receive  his 
pay  immediately.  The  American  importer  goes  to  his 
bank,  say  Ba,  and  asks  for  a  letter  of  credit.  If  the 
circumstances  warrant  it,  Ba  issues  such  a  letter,  which 
is  in  the  form  of  a  request  on  Bg,  the  London  corre- 
spondent of  Ba,  to  accept,  up  to  a  given  amount  and 
under  specified  conditions,  the  drafts  of  the  South 
African  exporter.  The  London  bank  is  informed  that 
such  a  request  on  it  has  been  issued  to  the  importer. 
The  American  importer  sends  this  letter  to  South  Africa, 
and  the  exporter  there  is  then  in  a  position  to  draw  a 
draft  on  the  London  bank,  Be,  instead  of  on  the  Ameri- 
can importer  or  his  bank,  Ba.  If  the  draft  is  drawn  for 
90  days  after  sight,  the  American  importer  has  that 
length  of  time  to  settle.  The  goods  are  billed  to  his 
bank,  Ba,  which  issued  the  letter  of  credit;  and  the 
bank  will  probably  let  him  take  over  the  goods  upon  his 
signing  a  trust  receipt  securing  the  bank.  The  draft 
drawn  in  South  Africa  is  sent  to  London,  presented, 
"accepted,'^  and  sold  in  the  discount  market.  The  bill 
of  lading  and  insurance  certificate  were  attached  to  the 
draft  to  begin  with,  but  when  the  latter  is  "accepted" 
the  London  bank  detaches  all  documents  and  sends 
them  to  the  New  York  bank  so  that  the  goods  may  be 


96    THE  EXCHANGE  MECR\NISM  OF  COMMERCE 

secured  upon  arrival.  By  the  time  the  draft  is  due,  the 
American  importer  has  paid  his  bank  and  it  has  settled 
with  the  London  bank.  This  then  is  another  illustra- 
tion of  borrowing  by  a  business  man  or  business  men  in 
the  United  States,  the  real  lender  or  creditor  being  the 
purchaser  of  the  draft,  in  the  London  discount  market, 
and  through  him  the  depositors  in  some  English  bank. 

One  of  the  chief  reasons,  in  fact,  for  the  use  of  a  letter 
of  credit,  is  to  enable  the  exporter  to  draw  on  London 
or  some  other  well-known  banking  centre.  His  draft 
will  then  bring  the  highest  possible  price.  London, 
as  the  principal  banking  and  exchange  centre  of  the 
world  and  a  great  exchange  discount  market,  is  most 
frequently  the  place  drawn  on.  The  exporter  can  get 
immediate  payment  ^  and  the  importer  can  get  credit. 

§8 

Place  Speculation  or  Arhitr aging  in  Exchange 

Just  as  there  may  be  place  speculation  and  time  specu- 
lation in  the  case  of  commodities,  so  both  of  these  types 
of  speculation,  or  something  analogous  to  them,  exist 
in  the  case  of  drafts.  Corn  may  be  sent  from  a  place 
where  it  is  relatively  cheap  to  a  place  where  it  is  rela- 
tively dear.  This  is  arbitraging  in  corn.  Similarly 
there  is  arbitraging  in  exchange.^  Arbitraging  in  ex- 
change involves  the  purchase  of  drafts  on  one  place  and 
the  sale  of  drafts  on  another.  Thus,  if  in  New  York 
exchange  on  London  is  high  while  exchange  on  Paris  is 

*  If  the  letter  of  credit  is  "confirmed"  by  the  bank  made  drawee,  then  pay- 
ment is  absolutely  guaranteed  to  the  exporter,  even  before  his  bill  is  "accepted." 
See  Margraff,  International  Exchange,  Chicago  (Fergus  Printing  Co.),  1903,  pp. 
88,  89. 

2  Described  in  Escher,  Elements  of  Foreign  Exchange,  pp.  98-101. 


THE  RATE  OF  EXCHANGE  97 

low ;  and  if  in  Paris,  exchange  on  London  is  fairly  low, 
an  arbitraging  transaction  would  be  profitable.  The 
arbitrager  in  New  York  would  buy  exchange  on  Paris, 
would  instruct  his  Paris  correspondent  to  buy  exchange 
on  London,  and  would  then  be  able  to  sell  in  New  York, 
exchange  on  London.  Thus  the  cheaper  exchange  on 
London,  available  in  Paris,  is  shifted  to  New  York. 
Exchange  on  London  is  sold  from  Paris  where  it  is  cheap, 
to  New  York  where  it  is  dear.  This  activity  by  arbi- 
tragers, of  course,  tends  to  Hmit  the  variations  in  price 
at  different  places,  of  exchange  on  any  one  point.  It 
is  seldom  possible  to  make  a  very  considerable  per  cent 
gain  by  such  transactions. 

§9 

Time  Speculation  in  Exchange 

Besides  arbitraging  or  place  speculation,  there  is 
also  time  speculation  in  exchange.  As  with  produce, 
e.g.  wheat,  this  speculation  in  time  may  be  speculative 
holding,  buying  and  selling  of  futures,  and  (a  part  of 
future  selHng)  selling  short.  Suppose  a  New  York  bank 
to  purchase  bills  of  exchange  on  London  and  to  send 
them  over  for  discount  {i.e.  sale),  either  for  immediate 
discount  or  for  discount  as  occasion  requires.  The 
New  York  bank  is  then  accumulating  in  England  a  basis 
for  its  own  drafts.^  If,  at  the  time,  bills  of  exchange 
on  England  are  purchasable  at  a  low  price,  the  New 
York  bank  will  be  more  likely  to  buy,  and  later,  when 
exchange  is  higher,  it  will  be  under  greater  temptation 
to  sell.     If  the  New  York  bank  buys  exchange  when  the 

1  Cf.  Clare,  The  A. B.C.  of  the  Foreign  Exchanges,  p.  87 ;  and  Escher,  Elements 
of  Foreign  Exchange,  p.  30- 
H 


98    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

rate  is  low,  then  its  buying  tends  to  keep  up  the  rate, 
and  when  it  later  sells,  at  relatively  high  prices,  its  sell- 
ing tends  to  keep  the  rate  down.  This  kind  of  trans- 
action, therefore,  acts  on  the  exchange  market  just  as 
speculative  holding  of  wheat  acts  on  the  wheat  market, 
namely  in  the  direction  of  equalization.  Such  specula- 
tive holding  of  exchange,  in  so  far  as  it  exists,  serves  to 
decrease  the  alternate  import  and  export  of  gold.  When 
exchange  here,  on  England,  is  low  because  of  the  excess 
of  obligations  from  them  to  us,  a  part  of  this  excess  of 
obligations  may  take  the  form  of  available  credit  for 
American  banks  with  EngUsh  banks.  So  much,  there- 
fore, of  the  excess  of  obHgations,  need  not  be  settled  by 
the  shipment  of  gold.  Later,  when  gold  tends  to  flow 
from  the  United  States  to  England,  this  accumulated 
credit  in  England  obviates  the  necessity  of  so  great  a 
flow  of  gold  as  would  else  occur.  We  may  say  that, 
since  part  of  the  money  which  was  collectible  by  Ameri- 
can banks  (though  perhaps  collectible  only  through 
the  London  discount  market),  is  allowed  to  remain  as 
a  credit  in  England,  either  as  bank  credit  or  as  long  bills 
not  discounted  but  held  for  account  of  American  banks,^ 
the  later  obKgations  to  England  are  paid  partly  by  draw- 
ing on  that  credit  instead  of  shipping  gold. 

There  is  also  the  buying  and  selHng  of  futures  in 
exchange.  To  illustrate,  an  exporter  may  know  long 
in  advance  that  he  is  to  ship  goods  of  a  certain  value 
at  a  given  time.  He  will  then  be  able  to  draw  a  draft 
on  the  purchaser  of  these  goods.  But  if  he  waits  until 
he  has  sold  the  goods  before  making  any  arrangements 
regarding  his  draft,  he  simply  takes  the  risk  of  selling 

*  For  further  explanation  of  the  nature  and  method  of  these  transactions,  see 
Ch.  VI  (of  Part  I),  §  2. 


THE  RATE  OF  EXCHANGE  99 

the  draft  on  his  debtor  for  whatever  is  the  ruling  price 
at  the  time  of  the  sale.  He  can,  however,  contract 
ahead  for  the  disposal  of  his  draft  to  some  exchange 
dealer  or  banker,  at  an  agreed  price.^  He  is  selling  or 
agreeing  to  sell  future  exchange. 

Sometimes  a  bank  remits  drafts  to  its  foreign  corre- 
spondent, some  of  which,  being  payment  bills,  cannot 
be  immediately  discounted  for  cash.^  These  bills  will, 
of  course,  with  few  if  any  exceptions,  eventually  be  paid ; 
and  if  there  are  very  many  of  them,  then  the  remitting 
bank  can  estimate,  because  of  the  constancy  of  averages, 
at  about  what  dates  they  will  be  paid.  This  bank  is 
therefore  in  a  position  to  promise  that  it  will  sell  demand 
drafts  on  its  correspondent  abroad,  at  given  dates  and 
for  given  amounts.  It  promises  to  sell  these  drafts 
at  some  future  time  when  it  can  be  sure  of  having  the 
balance  abroad  on  which  to  draw.^  In  this  case  the 
future  seUing  is  done  by  a  bank.  By  making  such  an 
arrangement,  the  bank  guards  itself  against  the  risk 
of  unfavorable  exchange  rate  fluctuations.  By  selling 
futures  against  futures  a  bank  can  relieve  itself  entirely 
from  risk  of  such  fluctuations.  The  bank  buys  or  con- 
tracts to  buy,  an  exporter's  future  bills,  and  at  the  same 
time  sells  or  contracts  to  sell,  its  own. 

As  in  other  dealing,  so  in  foreign  exchange,  one  kind 
of  "future"  selling  is  selling  "short."  To  sell  "short" 
is  to  agree  to  sell  at  a  future  time,  without  having,  at 
the  time  of  making  the  agreement,  the  means  to  deliver, 
but  relying  upon  later  purchases  to  "cover"  the  shortage. 
A  man  sells  wheat  short  if  he  contracts,  say  in  March, 

>  See  Escher,  Elements  of  Foreign  Exchange,  p.  35. 

»  See  Ch.  Ill  (of  Part  I),  §  7. 

•Escher,  Elements  oj Foreign  Exchange,  p.  loi. 


icx)    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

to  sell  for  May  delivery,  counting  on  his  ability  to  pur- 
chase the  wheat  in  May,  in  order  to  make  good  the  agree- 
ment. Similarly  an  exchange  dealer  sells  short  if  he 
agrees  to  sell  a  draft,  e.^.  in  June  for  August  delivery, 
but  has,  when  the  contract  is  made,  no  bank  balance 
abroad  or  salable  drafts  held  in  his  name  in  some  foreign 
bank,  on  which  he  may  draw.  He  relies  upon  August 
purchases  of  bills  to  provide  this  foreign  balance.  The 
same  in  principle  as  short  selling  is  the  finance  bill  al- 
ready described,  and  other  similar  bills.  In  the  case  of 
the  finance  bill,  one  bank  does  not  merely  promise  to 
sell  at  a  future  time ;  it  actually  does  sell,  in  the  present, 
a  draft  on  another  bank  where  it  has  at  the  time  no 
credit  balance  and  no  deposit  of  discountable  bills. 
This  draft,  though  sold  in  the  present,  is  of  course  for 
future  payment.  It  is  a  draft  for  60  or  90  days  or  for 
some  other  period.  It  requires  to  be  ^'covered"  before 
maturity.  Hence  it  may  properly  be  classed  with  or 
alongside  of  other  short  selling. 

§  10 
Summary 

The  starting  point  of  our  discussion  of  the  rate  of 
exchange  has  been  supply  and  demand.  At  any  given 
time  the  price,  say  in  New  York,  of  drafts  on  London; 
i.e.  the  rate  of  exchange  on  London,  is  fixed  where  supply 
of  and  demand  for  such  exchange  are  equal.  Thus, 
exchange  may  go  above  or  below  par,  the  mint  equiva- 
lent in  coinage. 

Going  back  of  supply  and  demand,  we  found  that 
these  depend  upon  purchases  and  sales,  investments, 
interest  and  dividends,  etc.     Whatever  tends  to  increase 


THE  RATE  OF  EXCtjA^G^:  /  ;  ip? 

the  total  payments  to  be  made  by  Americans  to  English- 
men tends  to  increase  the  demand  here  for  drafts  on 
England.  Vice  versa,  whatever  increases  the  total 
payments  to  be  made  from  them  to  us  increases  the 
supply  here  of  drafts  on  England  (or  decreases  the  de- 
mand). 

Analysis  of  the  short  time  loan  by  a  foreign  bank,  of 
the  so-called  finance  bill,  and  of  investment  here  by  an 
American  and  a  foreign  bank  for  joint  account,  led  to 
the  conclusion  that  in  all  cases  the  borrower  was  the 
business  firm  here  which  profited  by  the  loan,  while  the 
ultimate  lender  was  the  person  in  the  London  or  other 
discount  market  who  bought  the  bill  and  held  it  till 
maturity,  or  the  depositors  of  the  bank  from  which  such 
a  buyer  obtained  the  means  of  purchase.  In  the  case 
of  some  of  these  bills,  most  of  all,  perhaps,  the  finance 
bill,  there  is  probably  a  tendency  for  more  to  be  sold, 
other  things  equal,  at  those  times  of  year  when  gold 
must  otherwise  be  more  largely  exported;  and  to  be 
redeemed,  later,  when  gold  must  otherwise  be  more 
largely  imported.  The  letter  of  credit  is  a  scheme  to 
get  immediate  payment  for  an  exporter,  a  period  of 
credit  for  an  importer,  and  a  chance  for  the  exporter 
to  make  out  a  draft  on  an  important  financial  centre  and 
therefore  a  more  salable  draft  than  he  might  else  have. 
As  with  the  finance  bill,  short  time  loan,  etc.,  the  credit 
is  really  furnished  by  investors  or  by  bank  depositors 
in  the  discount  market  of  the  big  banking  centre,  most 
likely  London,  where  the  draft  is  sold. 

Exchange  is  speculated  in,  much  as  are  wheat,  corn, 
stocks,  etc.  There  may  be  arbitraging  in  exchange,  i.e. 
sending  exchange  on  some  point,  from  where  it  is  rela- 
tively cheap  to  where  it  is  relatively  dear.    Exchange 


:i(f2:  TBE^KXCHANGE  MECHANISM  OF  COMMERCE 

may  be,  in  a  sense,  held  for  a  rise,  thus  tending  to  steady 
the  exchange  market  and  decrease  the  flow  of  specie; 
it  is  subject  to  "future"  deahngs;  it  is  sold  "short." 
The  finance  bill  is  really,  in  principle,  a  kind  of  short  sell- 
ing of  exchange.  An  agreement  to  sell  at  some  future 
date,  relying  upon  purchases  of  exchange  in  the  mean- 
while, to  cover,  is  clearly  selling  short. 


CHAPTER  V 
The  Rate  of  Exchange  and  the  Flow  of  Specie 

§1 

The  Upper  Limit  to  Fluctuation  of  the  Rate  of  Exchange, 
Determined  by  the  Cost  of  Exporting  Specie 

We  have  seen  that,  by  the  use  of  finance  bills  and  other 
similar  arrangements,  the  excessive  obligations  of  a 
country  to  other  countries  during  any  short  period  may 
be  in  part  balanced  by  the  reverse  obligations  of  a  later 
period.  We  have  also  seen  that,  by  speculative  holding 
(accumulation)  of  exchange,  the  surplus  obHgations  to  a 
country  during  an  earHer  period  may  be  used  to  offset, 
in  part,  the  obligations  incurred  by  it  in  a  later.  But 
sometimes  there  will  be  a  net  balance  of  obKgations  in  one 
direction  for  several  months  or  a  year  or  a  series  of  years. 
If  so,  the  obligations  probably  will  not  be  Hquidated  for 
the  most  part  by  postponement  or  by  exchange  accumu- 
lation. The  demand  for  bills  with  which  to  meet  a  long 
continued  balance  of  indebtedness  will  hardly  be  satisfied 
by  the  sale  of  finance  bills  or  other  bills  of  similar  nature, 
for  the  bankers  of  a  country  cannot  be  indefinitely  add- 
ing to  their  obligations  of  this  sort  and  not  repaying. 
Neither  will  the  supply  of  bills  caused  by  a  long  continued 
excess  of  obKgations  to  a  country  be  taken  care  of  by 
speculative  purchase  and  holding  for  a  rise,  since  there  is 
a  limit  to  the  amount  which  bankers  can  afford  to  invest 
in  such  speculative  holding.    If,  therefore,  our  obliga- 

103    


I04  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

tions  are  larger  for  any  great  length  of  time  than  the 

obHgations  to  us,  there  will  be  a  great  demand  for  bills  of 

exchange  with  which  to  remit  and  there  will  be  a  relative 

scarcity  of  such  bills.     Consequently,  the  price  of  bills 

or  the  rate  of  exchange  on  other  countries,  which  will 

/    equalize  supply  and  demand,  must  maintain  a  fairly  high 

y^        average.     On  the  other  hand,  if  obligations  to  us  are  for 

y^/^         a  long  period  in  excess,  the  rate  of  exchange  here,  on 

foreign  countries,  must  be  fairly  low,  else  the  supply  of 

drafts  on  these  countries  will  exceed  the  demand. 

Are  there  any  Hmits,  upper  and  lower,  to  the  rate 
exchange  may  reach  ?  Are  there  any  limits,  for  instance, 
upper  and  lower,  to  the  price  that  drafts  on  London  may 
command  in  New  York?  If  there  are,  what  forces 
determine  these  Limits  ? 

Let  us  consider,  first,  the  question  of  an  upper  limit  of 
exchange.  The  price  in  the  United  States,  of  drafts  on 
England,  will  not  go  above  par  by  much  more  than  the 
cost  of  shipping  specie.  For  if  it  does  so,  either  the 
demand  for  such  drafts  will  decrease,  or  the  supply  will 
increase,  or  both,  to  such  an  extent  that  supply  will 
exceed  demand.  A  rise  of  exchange  above  par  by  more 
than  the  cost  of  specie  shipment  must  decrease  the 
demand  for  drafts,  because  many  of  those  in  this  country 
who  are  debtors  will,  if  their  debts  are  large,  find  it 
cheaper  to  ship  specie  than  to  buy  drafts.  It  is  true  that 
in  some  cases  the  debts  of  merchants,  etc.,  are  settled 
by  their  English  creditors  drawing  on  them.  But  if 
so,  the  bills  drawn  on  these  Americans  have  to  be  sent 
to  American  banks  for  collection  and  these  American 
banks  must  then  settle  with  the  English  banks  sending 
the  drafts.  And  if  the  rate  of  exchange  goes  above  par 
by  more  than  the  cost  of  shipping  gold,  American  banks 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     105 

having  large  remittances  to  make  will  prefer  to  ship  gold 
rather  than  to  buy  for  shipment  the  more  expensive  bills 
of  exchange.  As  a  matter  of  fact,  merchants,  manu- 
facturers, etc.,  will  rarely  have  the  facilities  and  knowl- 
edge or  the  large  indebtedness  to  warrant  their  shipping 
gold,  and  will  continue  to  send  drafts.  But  debtor  banks 
frequently  do  ship  gold.  We  may  say,  then,  that  at  a 
rate  of  exchange  much  farther  above  par  than  the  cost 
of  shipping  specie,  the  demand  here  for  drafts  on  Eng- 
land (and  other  foreign  countries)  would  fall  short  of  the 
supply.     Therefore,  such  a  rate  could  not  continue. 

We  arrive  at  the  same  conclusion  from  a  study  of  the 
supply  side  of  the  market.  If  the  rate  of  exchange,  i.e, 
the  price  of  drafts,  rises  above  par  by  more  than  the  cost 
of  specie  shipment,  then  it  will  pay  some  banks,  even 
though  they  owe  nothing,  to  export  gold.  The  gold  will 
be  exported  to  a  consignee,  say  a  foreign  correspondent 
bank  in  London.  Then  the  American  bank  can  count 
on  having  a  balance  or  drawing  account  in  the  London 
bank,  in  the  same  manner  as  if  drafts  had  been  sent. 
On  this  balance,  the  American  bank  can  draw  its  own 
drafts  for  sale  in  the  United  States,  at  the  high  ruling  rate, 
to  persons  having  remittances  to  make.  By  so  doing, 
the  bank  adds  to  the  supply,  here,  of  drafts  on  England, 
and  the  ordinary  business  man  has  no  occasion,  himself, 
to  ship  gold.  So  a  rise  in  the  price  of  drafts  on  England, 
beyond  a  certain  point,  will  tend  to  increase  the  supply 
of  such  drafts.  And  at  a  price  which  exceeds  par  by  much 
more  than  the  cost  of  shipping  specie,  supply  would  al- 
most necessarily  exceed  demand,  because  the  shipment 
of  specie  on  which  to  sell  drafts  would  be  so  profitable. 
It  follows  that  the  rate  of  exchange  cannot,  ordinarily, 
be  expected  to  exceed  par  by  much  more  than  the  gold 


io6  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

shipment  cost.  It  is  kept  down  by  forces  on  the  supply 
^  side  of  the  market,  as  well  as  by  forces  on  the  demand 
side. 

We  may  fairly  assume  the  cost  of  gold  shipment 
between  New  York  and  London  to  be,  for  large  quanti- 
ties, about  $2  per  £ioo,  including  charge  for  transporta- 
tion, insurance,  and  all  other  expenses.  Then,  since  par 
between  New  York  and  London  is  $486.65  =  £100,  the 
price  in  New  York  of  sight  drafts  on  London  could  not 
much  exceed  $488.65  =  £100.  So  soon  as  it  gets  as 
high  as  that  or  higher,  it  becomes  as  cheap  or  cheaper  for 
New  York  banks  to  settle  their  indebtedness  to  English 
banks  by  purchasing  and  shipping  gold  as  by  purchasing 
and  shipping  drafts.  A  draft  on  London  for  £100  would 
cost,  if  exchange  were  at  its  highest  point,  $488.65  or 
more.  But  if  $486.65  in  gold  could  be  shipped  to  London 
/  for  $2,  making  a  total  expense  of  $488.65,  no  New  York 
bank,  having  a  remittance  to  make,  would  pay  a  higher 
price  for  a  draft.  Hence  the  demand  for  drafts  on  Eng- 
land must  fall.  Likewise,  so  soon  as  exchange  gets 
higher  than  $488.65  =  £100,  it  becomes  profitable  for 
New  York  banks  to  purchase  gold,  ship  it  abroad,  and 
sell  drafts  drawn  on  the  credit  so  secured.  $486.65  in 
gold  plus  $2  for  shipment,  loss  of  interest,  insurance,  etc., 
makes  $488.65,  total  expense.  The  $486.65  is  worth  in 
England,  mint  equivalent,  £100.  If  a  draft  on  the 
English  consignee  for  £100  will  sell  for  more  than 
$488.65,  it  is  obviously  profitable  to  ship  gold  and  sell 
drafts.  To  ship  drafts  instead  of  gold  might  be  less 
profitable,  because  of  their  high  price.  Because  of  gold 
shipments,  the  supply  of  drafts  on  England  must  be 
greater. 

The  cost  of  gold  shipment,  however,  may,  under  the 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     107 

pressure  of  special  circumstances,  go  far  above  $2  per 
£100;  and  this  cost  is,  therefore,  a  somewhat  elastic 
rather  than  a  definitely  rigid  limit  to  the  possible  rise 
of  exchange.  For  example,  the  prospect  of  a  great  Eu- 
ropean war  caused  insurance  rates  on  gold  shipments  to 
Europe  to  rise  as  high  as  i  per  cent  on  July  30  and  31 
of  this  year  (1914).^  Such  charges,  nearly  $5  per  £100 
for  insurance  alone,  at  a  time  when  there  was  a  strong 
movement  in  foreign  countries  to  sell  securities  and  real- 
ize gold,  and  when,  consequently,  the  United  States  was 
exporting  gold,  made  possible  a  rise  in  exchange  rates 
much  above  the  usual  upper  limit.  In  fact,  the  foreign 
exchange  market  seems  to  have  been,  in  this  case,  com- 
pletely demoralized  by  the  suddenness  of  the  crisis.^ 
The  immediately  ensuing  outbreak  of  war  on  an  extended 
scale  brought  a  sudden  check  to  trade  in  general,  in- 
cluding the  export  of  gold.  One  vessel,  the  Kronprin- 
zessin  Cecilie  of  the  North  German  Lloyd  Company, 
which  had  left  New  York  July  28  carrying  over 
$10,000,000  in  gold  and  silver  consigned  to  Enghsh  and 
French  banking  houses,  returned  with  her  cargo  to  the 
United  States  (Bar  Harbor,  Me.,  Aug.  4)  rather  than 
risk  capture.^ 

§2 

Some  Details  Connected  with  the  Exportation  of  Specie 

A  number  of  details  of  the  gold  export  operation  may 
now  claim  our  attention.  Let  us  consider  first  the  loss 
of  interest  during  transportation  of  the  gold.  If  it  takes 
seven  days  to  transport  the  gold  and  if  the  draft  drawn 
upon  it  is  sold  when  the  gold  is  shipped  and  goes  abroad 

1  See  New  York  World,  July  31  and  Aug.  i,  1914, 

*Ibid.,  July  31,  1914. 

'  New  Haven  Evening  Register,  Aug.  4,  1914. 


io8  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

at  about  the  same  time,  this  draft  can  hardly  be  honored  in 
less  than  seven  days.  The  purchaser  of  the  draft,  there- 
fore, must  pay  for  it  seven  days  before  his  foreign  creditor 
can  receive  the  money,  and  so  must  lose  seven  days  inter- 
est. The  alternative  to  such  a  purchase  would  be  to 
wait  seven  days  and  buy  a  cable.  If  he  buys  the  banker's 
draft  on  the  gold  he  will,  presumably,  pay  very  slightly 
less  for  it  in  consequence  of  this  period  of  waiting. 
Accordingly,  the  price  received  by  the  drawing  bank  is 
very  sHghtly  less.  Any  demand  draft,  however,  other 
than  a  cable,  must  suffer  such  a  deduction  for  interest.  / 
And  demand  drafts  drawn  when  goods  are  shipped,  on 
the  consignees,  cannot  usually  be  cables,  since  the  con- 
signees cannot  be  expected  to  pay  for  goods  before 
receiving  them.  Any  exporter,  then,  may  be  said  to  lose 
interest  in  the  same  way.  He  ships  goods  which  may  not 
reach  their  destination  for  several  days  or  weeks.  If  they 
arrive  on  the  same  steamer  as  his  draft  (which  is  at  once 
shipped  by  the  purchasing  American  bank),  the  draft 
may  be  made  payable  at  sight.  But  even  then  there  is 
time  lost.  Had  the  goods  been  sold  at  home,  this  loss 
need  not  have  occurred.  It  is  one  of  the  deductions  from 
the  benefits  of  trade  between  widely  separated  areas, 
that  wealth  in  transit  is  temporarily  kept  out  of  use. 
The  American  exporter  may  get  more  for  his  goods,  if 
sold  in  England,  than  he  could  get  at  home,  and  the 
English  buyer  may  get  these  goods  more  cheaply  than  if 
he  purchased  them  in  his  own  country.  This  gain  to 
both  parties  will  presumably  exceed  all  losses,  including 
the  loss  of  time,  incident  to  handling  and  transporting 
the  goods.  Otherwise  the  trade  would  not  take  place. 
But  the  cost  of  transportation  makes  the  net  gains  con- 
siderably less  than  they  would  else  be,  and  the  loss  of 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     109 

time  involved  makes  them  somewhat  less.  The  exporter 
of  any  goods,  then,  may  be  said  to  lose  something  in 
interest  when  he  sells  a  sight  draft  on  the  consignee, 
though  the  price  he  receives  for  the  goods  may  make  the 
transaction  well  worth  while.  The  gold  exporting  bank 
is  no  exception.  This  slight  loss,  however,  is  not  ordi- 
narily reckoned  as  one  of  the  expenses  of  exporting  gold. 
The  banker  thinks  of  the  price  his  draft  brings,  as  his 
receipts,  and  does  not  regard  the  sKght  reduction  below 
what  it  would  yield  if  collectible  at  once,  as  an  expense. 
Insurance  of  the  gold,  transportation  charges,  etc.,  are 
deductions,  along  with  the  cost  of  the  gold,  from  his  gross 
returns,  and  these  he  regards  as  his  expenses. 

When  gold  is  exported,  it  must  be  assayed,  weighed, 
etc.,  on  arrival,  and,  since  this  requires  some  three  days, 
there  must  be  subtracted  interest  for  that  time  from 
the  shipper's  gross  profit.  If  the  draft  drawn  upon  the 
gold  is  a  sight  draft,  it  may  be  presented  and  paid  three 
days  before  the  gold  shipped  can  rightly  be  credited 
to  the  drawer.  If  so,  there  is  technically  an  "overdraft" 
on  which  interest  has  to  be  allowed  by  the  American  gold 
exporting  bank^  to  the  EngHsh  consignee  bank.  That 
is,  this  interest  must  be  deducted  from  the  balance  in 
England  on  which  the  American  bank  can  draw.  When 
the  American  bank  exports  gold  as  the  cheapest  means  of 
settling  a  debt,  there  is  the  same  loss  of  time,  and  so,  in 
a  sense,  loss  of  interest,  during  assaying,  weighing,  etc., 
as  well  as  during  transit. 

Still  another  detail  should  be  mentioned.  In  New 
York,  or  at  any  United  States  sub  treasury,  gold  is  always 
purchasable  with  dollars  {e.g.  United  States  notes,  gold 

1  See  Escher,  Elements  of  Foreign  Exchange,  New  York  (The  Bankers  Publish- 
ing Co.),  1911,  PP-  114,  115- 


no  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

certificates  or  silver)  at  the  same  rate  or  price.  An 
ounce  of  pure  gold  is  always  worth  $20,671,  and  an  ounce 
of  gold  9/10  fine  is  worth  $18,604.  The  sub  treasuries 
aim  to  have  bar  gold  available,  but  if  the  supply  is 
exhausted,  then  gold  coin  can  be  secured  for  export. 
There  is  no  question,  therefore,  here,  as  to  the  cost  of  the 
gold  to  be  shipped.  But  there  is  some  variation  in  the 
amount  of  coin  of  the  realm  w^hich  the  specie  may  be 
worth  on  arrival  in  Great  Britain.  This  is  because, 
while  the  bank  of  England  is  by  law  compelled  to  pay 
£3  175.  gd.  per  ounce  for  gold,  the  mint  equivalent  of 
an  ounce  is  £3  175.  io\d.  Any  one  can  get  the  larger 
amount  for  his  gold  by  waiting  to  have  it  coined.  But 
on  account  of  the  delay  and  consequent  loss  of  interest 
while  the  gold  is  being  coined,  together  with  the  labor  of 
weighing  and  assaying,  the  bank  is  not  compelled  to  give 
the  mint  par  for  gold;  though,  to  relieve  others  of  the 
necessity  of  waiting,  it  is  under  obligation  to  give  for 
it  the  somewhat  less  price  stated  above.  The  bank,  how- 
ever, may  have  sufficient  use  for  gold,  for  reserve,  export, 
or  other  purpose,  so  that  it  will  bid  the  full  mint  price  or 
even  more.  If  all  gold  coins  were  full  weight,  the  bank 
would  never  bid  more  than  the  mint  price,  since  coined 
gold  could  be  used  and  it  would  be  cheaper  to  use  coined 
gold  for  any  purpose  for  which  the  gold  bars  (or  bullion) 
might  be  desired,  than  to  pay  a  higher  price  for  the  latter. 
The  price  of  gold  would,  in  that  case,  fluctuate  between 
£3  175.  ()d.  and  £3  17^.  io\d.  In  fact,  it  may  and  some- 
times does  go  slightly  above  the  latter  price,  because  the 
bank  may  be  purchasing  gold  with  worn  coins,  which, 
while  within  the  legal  Kmit  of  tolerance  in  England, 
would  have  to  pass  by  weight  if  exported.  The  American 
bank  which  exports  gold  to  England  cannot  tell,  there- 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     iii 

fore,  just  what  it  will  be  worth  on  arrival  (though  doubt- 
less some  one  could  be  found  to  guarantee  a  price). 
The  money  value  on  arrival  will  depend,  slightly,  on 
what  is  being  offered  for  gold  at  the  time. 

Sometimes  the  export  of  gold  involves  a  triangular 
operation.^  For  instance,  Ba  wishes  to  get  a  balance 
with  Be  in  England,  on  which  to  sell  drafts.  Drafts 
on  England,  here,  are  high,  and  Ba  does  not  wish  to  buy 
any  in  such  a  market.  But  it  may  happen  that  in  Paris, 
drafts  on  London  are  below  par.  The  high  rate  in  New 
York  of  drafts  on  Paris,  however,  tends  to  discourage 
arbitraging.  Instead,  Ba  can  ship  gold  to  its  Paris 
correspondent,  Bf,  and  order  the  Paris  bank  to  buy  a 
draft  on  London.  This  draft  is  sent  to  London  for  dis- 
count, and  Ba  then  has  a  balance  in  London,  with  Be, 
on  which  it  can  draw  at  a  profit  above  cost. 

§3 

The  Lower  Limit  to  Fluctuation  oj  the  Rate  of  Exchange^ 
Determined  by  the  Cost  of  Importing  Specie 

As  the  rate  of  exchange  has  an  upper  limit,  though  of 
course  a  sUghtly  elastic  one,  so  also  it  has  a  lower  limit. 
If  exchange  falls  below  par  by  much  more  than  the  cost 
of  importing  specie,  either  the  supply  of  drafts  on  foreign 
countries  must  decrease,  or  the  demand  for  such  drafts 
must  increase,  or  both,  to  such  an  extent  that  sup- 
ply exceeds  demand.  The  supply  of  drafts  on  foreign 
countries  would  tend  to  decrease,  because  those  having 
collectible  debts  abroad  in  any  considerable  quantities, 
on  which  they  desired  to  realize,  would  find  it  cheaper 
to  pay  for  the  importation  of  specie  than  to  sell  at  so  great 

*  See  Escher,  Elements  of  Foreign  Exchange,  p.  120. 


112  THE  EXCHANGE  MECH.\NISM  OF  COMMERCE 

a  discount,  drafts  on  their  foreign  debtors.  Suppose,  for 
example,  that  exchange  in  New  York  on  London  were 
below  $484.65  =  £100.  Then  any  New  York  bank,  or 
other  person,  desiring  to  call  back  funds  h^ld  in  London 
or  to  collect  a  debt  from  there,  would  prefer  to  pay  $2 
per  £100  for  importation,  and  have  $486.65  minus  $2,  or 
$484.65  for  each  £100,  than  to  get  less  than  that  amount 
by  selHng  a  draft  at  a  very  low  rate  of  exchange.  This 
applies,  of  course,  only  when  the  circumstances  (or 
agreement)  are  such  that  the  creditor  is  obliged  to  bear 
the  risk  of  exchange  fluctuations.  Otherwise,  the  debtor 
would  be  expected  to  remit  draft  or  specie.  But  wher- 
ever settlement  is  to  be  made  at,  in  this  regard,  the 
creditor's  risk  (and  this  might  be  the  case,  for  example, 
where  a  creditor  bank  has  decided  to  withdraw  funds 
which  it  has  itself  put  on  deposit  abroad) ,  the  effect  of  a 
very  low  rate  of  exchange  on  any  point  would  be  to 
decrease  the  supply  of  drafts  on  that  point  and  substitute 
importation  of  specie.  With  exchange  so  low,  it  would 
pay  better  for  banks  to  withdraw  their  balances  from 
abroad  than  to  sell  drafts  upon  those  balances. 

A  low  rate  of  exchange,  below  $484.65  =  £100,  would 
also  tend  to  increase  the  demand  for  drafts.  For  such  a 
rate  of  exchange  would  make  it  worth  while  to  import 
gold  for  profit.  £100  of  full  weight  English  money  would 
be  worth,  in  this  country,  $486.65.  Subtracting  $2  as 
cost  of  transportation,  insurance,  etc.,  there  is  left 
$484.65.  If  the  gold  can  be  purchased  with  a  draft  on  an 
English  bank,  a  draft  which,  because  of  the  low  rate  of 
exchange,  costs  less  than  the  above  sum,  the  operation 
is  profitable.  (It  is  not  intended  to  assert  that  the  im- 
portation of  so  small  a  sum  would  be  profitable.  Rather 
is  it  here  assumed  that  the  £100  is  only  a  part  of  a  much 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     113 

larger  sum.)  The  low  price  of  drafts,  then,  stimulates 
the  demand  for  drafts  as  a  means  of  paying  for  English 
gold.  Thus,  on  the  supply  side  as  on  the  demand  side, 
there  is  a  Kmitation  on  the  extent  to  which  exchange  can 
fall.  The  lower  limit  of  exchange  fluctuations,  like  the 
upper  limit,  is  not,  however,  absolutely  and  permanently 
fixed,  since  the  cost  of  shipping  gold  may  vary,  —  for 
example,  by  higher  insurance  rates  in  war  time.  In 
practice,  the  ordinary  business  man  does  not  himself 
import  gold  but  takes  advantage  of  the  demand  for  his 
drafts  by  banks  which  use  the  drafts  to  pay  for  gold. 
With  importation  of  gold  from  England,  as  with  ex- 
portation to  England,  allowance  must  be  made  for  the 
possible  slight  fluctuation  in  the  price  of  gold  in  terms 
of  pounds  sterling. 

§4 

Circumstances  which  May  Cause  the  Rate  of  Exchange 

to  Fall  Below  what  is  Usually  its  Lower  Limit 

But  the  rate  of  exchange  may  sink  considerably  below 
what  is  ordinarily  the  gold  shipping  point  or  so-called 
specie  point,  in  times  of  panic  or  of  great  financial  disturb- 
ance accompanied  by  a  relatively  large  supply  of  ex- 
change.^ The  principles  involved  are  the  same  at  such 
times  as  always,  and  the  factors  to  be  considered  are  the 
same,  but  one  of  these  factors,  loss  of  time  or  loss  of  in- 
terest, comes  to  have  exceptional  importance.  If,  when 
panic  conditions  prevail,  sellers  of  goods  have  bills  on  for- 
eign purchasers,  they  will  be  anxious  to  realize  on  these 
bills  at  once.  In  a  crisis,  both  cash  and  credit  are  rel- 
atively hard  to  get.^  At  the  peak  of  the  crisis,  there  is  a 
so-called  stringency.   Interest  rates  are  high.   The  sellers  of 

^  See  Goschen,  The  Theory  of  the  Foreign  Exchanges,  London  (Effingham 
Wilson),  1896,  pp.  49-52  ;  also  Bastable,  The  Theory  of  International  Trade,  Lon- 
don (Macmillan),  1903,  pp.  85,  86.  » See  Ch.  II  (of  Part  I),  §  7. 


114  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

drafts  do  not  want  to  lose  interest  and  will,  therefore,  seU 
at  a  low  price  so  as  to  get  cash  immediately.  Especially 
if  their  creditors  are  pressing  them  hard  or  bank  loans  are 
difficult  to  get,  they  must  make  the  most  of  every  avail- 
able resource,  at  once.  Rather  than  wait  for  importa- 
tion of  gold,  they  would  sell  drafts  at  a  considerable 
reduction  below  the  usual  price.  It  is  the  same  when  the 
creditor  is  a  bank.  If,  at  such  a  time,  it  has  occasion 
to  draw  on  a  foreign  balance,  it  will  desire,  like  others,  to 
get  control  of  such  resources  at  once,  and  may  accept 
an  unusually  low  rate  of  exchange  rather  than  resort  to 
importation.  Neither  will  a  bank,  at  such  a  time,  be 
likely  to  import  gold  for  profit  unless  the  profit  is  excep- 
tionally great.  To  buy  gold  abroad  is  to  subject  itself 
to  a  considerable  wait  pending  the  arrival  of  the  gold, 
during  which  time  part  of  its  funds  are  unavailable  for 
other  business.  But  during  a  crisis  a  bank  is  least  Hable 
to  desire,  even  temporarily,  to  part  with  funds.  It  will 
be  induced  to  do  this  only  by  hope  of  an  exceptional 
profit,  only,  that  is,  if  the  price  of  the  exchange  which  it 
must  use  to  buy  foreign  gold  is  below  the  usual  gold 
importing  point.  Some  few  creditors  may  be  in  a  posi- 
tion to  secure  immediate  payment  by  cable.  But 
those  whose  claims  are  based  on  the  export  of  goods 
cannot  expect  thus  to  be  paid  in  advance  of  the  goods' 
arrival.  Furthermore,  at  a  time  when  the  balance  of 
indebtedness  is  from  foreign  countries  to  us  (and  it  is 
such  a  time  that  we  are  considering),  a  part  of  that 
indebtedness  must  be  settled  by  shipments  of  gold  and  so 
necessarily  requires  an  interval  of  waiting  while  the  gold 
is  in  transit.  It  is  this  necessary  wait,  most  unwelcome 
at  a  time  of  stringency,  which  forces  the  rate  of  exchange 
below  the  usual  specie  point. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     115 

§5 
The  Cost  of  Money  Shipment  in  Domestic  Exchange 

It  should  be  noted  that  the  principles  of  domestic 
exchange  are  not  different  from  those  of  foreign  exchange. 
Money  has  to  be  shipped  from  one  part  of  the  United 
States  to  another,  as  it  has  to  be  shipped  between  coun- 
tries, and  it  costs  something  to  ship  it.  But  in  domestic 
exchange  the  distances  average  less  and  the  expense  is 
smaller.  The  express  companies  will  carry  $1000  from 
New  York  to  Chicago  for  40  cents.^  To  carry  $486.65 
across  the  ocean,  pay  for  insurance,  weighing,  assay- 
ing, etc.,  costs  about  $2  (in  large  quantities),  or  over 
$4  per  $1000,  making  an  expense  more  than  ten  times 
as  great. 

Of  course  even  the  trifling  charge  of  carrying  money 
about  our  own  country  might  well  affect  the  price  of  drafts 
to  that  extent,  and  in  fact  it  does  so  when  banks  buy  and 
sell  domestic  exchange  of  and  to  each  other.  But  in 
dealing  with  customers,  it  is  usual  for  the  banks  to  pay 
no  attention  to  this  expense.  On  the  contrary,  they  pay 
to  their  customers  when  buying  the  latters'  drafts,  and 
charge  them  when  selling  drafts  to  them,  a  more  nearly 
flat  rate,  which  includes  only  a  proper  fee  for  bank 
services,  reasonable  interest  for  time  elapsing  before 
maturity,  and  reasonable  insurance  for  the  possibility 
of  non-payment.  The  up  and  down  fluctuations  of  ex- 
change between  the  shipping  Hmits  are  borne  by  the 
banks,  and,  since  they  gain  about  as  much  by  one  set  of 
fluctuations  as  they  lose  by  the  reverse  changes,  they  just 
about  make,  on  the  average,  a  fair  return  for  their  service 
to  the  community. 

^  See  Taussig,  Principles  of  Economics,  New  York  (Macmillan),  igii,  Vol.  I, 
p.  466. 


ii6  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

As  a  matter  of  fact,  such  a  small  proportion  of  the 
total  business  done  requires  shipment  of  actual  money 
that  the  expense,  considering  the  low  cost  of  domestic 
shipments,  may  well  be  regarded  as  negligible.  To 
illustrate,  a  New  York  bank  might  have  sold  $1,000,000 
of  drafts  on  Chicago  and  bought  $998,000  of  drafts  on 
Chicago.  It  might  then  be  necessary  to  ship  $2000  to 
Chicago  at  a  cost  of  80  cents.  But  this  would  be  an 
expense  for  the  entire  business  transacted,  extremely 
small,  and  the  bank  might  well  ignore  it.  At  any  rate, 
such,  in  domestic  exchange  within  the  United  States,  is 
the  custom. 

§6 

The  Long  Run  Effect  of  a  Balance  of  Payments  from  One 
Country  to  Another,  for  Commodities  or  Services 

So  far  we  have  discussed  chiefly  the  more  immediate 
efifects,  upon  the  exchange  market,  of  given  conditions. 
Let  us  now  consider  some  of  the  long  run  or  ultimate 
effects.  These  depend  mainly  on  the  relative  prices 
or  levels  of  prices  of  goods  in  different  countries.  We 
have  seen  that  the  determination  of  the  level  of  prices  in 
any  country  is  expressed  in  the  equation 

MV  +  M'V  =  pq  +  p'q'  +   etc., 

where  M  is  money,  M'  is  bank  deposits,  V  and  V  are 
velocities  of  circulation,  the  p's  are  the  prices  respectively 
of  different  kinds  of  goods,  and  the  q's  are  the  quanti- 
ties of  these  goods.  We  have  seen,  also,  that  M'  tends 
to  increase  or  decrease  in  sympathy  with  M.  We  have, 
therefore,  drawn  the  conclusion  that  if,  in  any  country, 
M  increases  faster  than  the  q's,  prices  will  rise,  while 
if  M  decreases,  they  will  fall. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     117 

Bearing  in  mind  these  facts,  lef"  us  now  consider  the 
long  run  influences  of  the  following  sources  of  exchange, 
on  the  rate  of  exchange  and  on  the  flow  of  money : 
a  —  Payments  for  commodities. 
a'  —  Payments  for  services,  e.g.  freight,  banking,  etc. 
h  —  Payments  of  funds  for  investments,  e.g.  interna- 
tional lending  and  investing. 
c  —  Payments  of  interest,  dividends,  etc.  on  such  invest- 
ments. 
c'  —  Payments  from  home  funds  to  persons  of  one  sec- 
tion or  country,  travelling  in  others. 
c" —  Payments  to  families  of  immigrants. 

Regarding  payments  for  commodities,  it  is  to  be  noted 
that  these  are  generally  purchased  where  they  can  be  got 
most  cheaply.  If  we  can  buy  most  commodities  more 
cheaply  in  England  than  here,  then  there  will  be  a  demand 
for  exchange  on  England  with  which  to  pay  for  them, 
and  exchange  on  England  will  rise.  If  such  a  condition 
(large  purchases  from  England)  lasts  for  any  great  while, 
the  rate  of  exchange  will  probably  go  high  enough  to 
encourage  the  exportation  of  gold.  As  a  consequence, 
since  in  each  country  there  is  a  relation  between  gold 
bullion  and  money ,^  M,  and  therefore  M'  also,  will 
increase  in  England  and  decrease  here.  Prices  will  rise 
there  by  comparison,  and  fall  here.  We  shall  cease  to 
buy  so  much  in  England,  and  England  will  buy  more  of 
us.  Great  purchases  by  us  of  foreigners  tend,  therefore, 
to  cause  great  purchases  by  foreigners  of  us.  Money 
flows  one  way  or  the  other  because  commodities  are  pur- 
chased, all  things  considered,  where  they  are  cheapest. 
Briefly,  commodities  are  bought  where  prices  are  low; 
the  rate  of  exchange  elsewhere  on  these  low  price  places 

1  See  Ch.  I  (of  Part  I),  §  7. 


ii8  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

is  therefore  high ;  gold  is  therefore  shipped  to  the  low 
price  places,  and,  since  it  is  in  large  part  coined,  because 
of  the  law  of  flow  between  bullion  and  coin,  prices  in 
those  places  tend  to  rise.  Though  equihbrium  is  ever 
being  departed  from,  it  is  ever  tending  to  be  restored. 

But  this  does  not  mean  that  if,  for  instance,  wheat  is 
cheaper  in  the  United  States  than  in  England,  and  Eng- 
land buys  wheat  of  us,  we  then,  when  Enghsh  prices 
have  fallen  and  ours  have  risen,  begin  in  turn  to  buy 
wheat  of  England.  Wheat  never  becomes  cheaper  there 
than  here.  What  is  more  likely  to  happen  is  that,  when 
our  prices  rise  and  theirs  fall,  they  will  buy  less  of  our 
wheat  than  before,  and  either  raise  more  themselves, 
buy  more  elsewhere,  use  a  substitute,  or  simply  get  along 
with  less.  We,  on  the  contrary,  when  prices  have  fallen 
in  England  and  risen  here,  will  perhaps  buy  more  cotton 
cloth  in  England,  and  either  make  less  here,  buy  less  else- 
where than  in  England,  substitute  it  for  another  kind 
of  cloth,  or  use  more  cloth. 

A  purely  superficial  consideration  might  lead  to  the 
conclusion  that  we  can  always  buy  goods  in  England  more 
cheaply  when  exchange  on  England  is  low.  A  lot  of 
Enghsh  goods  worth  £ioo  or,  in  our  money,  at  the  mint 
equivalent,  $486.65,  might  cost  $489  if  exchange  were 
high  and  only  $484  or  some  $5  less,  if  exchange  on  Eng- 
land were  low.  But  the  conclusion  that  low  exchange  on 
England  means  an  opportunity  to  buy  goods  there  more 
cheaply  appUes  with  certainty  only  on  the  supposition 
that  other  things  are  equal.  And  the  very  fact  that 
exchange  on  England  is  low  is  evidence  that  other  things 
are  not  equal.  Low  exchange  on  England  indicates,  as 
we  have  seen,  a  large  supply  of  drafts  on  England. 
Therefore  it  probably  indicates  that  we  have  been  selling 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     119 

to  England  a  relatively  large  amount  and  buying  from 
England  a  relatively  small  amount  of  goods.  The  pre- 
sumable cause  of  this  situation  is  relatively  high  prices 
there  and  relatively  low  prices  here,  as  compared  with 
other  times  or  seasons.  To  be  specific,  at  the  time  when 
low  exchange  would  enable  us  to  buy  in  England  £100 
worth  of  goods  for  $484,  it  is  probable  that  prices  in 
England  are  comparatively  high  and  that  £100  will  buy 
less  there  than  at  other  times,  compared  with  what  money 
will  buy  here.  Expressing  the  fact  in  general  terms,  we 
may  say  that,  when  money  has  flowed  from  here  to 
England  in  such  quantities  as  to  make  their  prices  higher 
and  ours  lower,  it  pays  to  sell  to  them  rather  than  to  buy 
from  them,  even  though,  at  such  a  time,  exchange  on 
England  is  below  par.  Low  exchange  on  foreign  coun- 
tries does  tend  to  stimulate  importation,  and  high 
exchange  to  stimulate  exportation,  but  exchange  fluc- 
tuations are  too  narrow  to  be  of  determining  influence. 
If,  for  example,  Americans  purchase  largely  in  England, 
the  necessity  of  remitting  will  make  exchange  on  Eng- 
land high,  and  will  in  so  far  discourage  further  purchases 
from  England,  while  encouraging  sales  to  England  and 
encouraging  English  merchants  to  purchase  goods  here. 
But  exchange  cannot  rise  high  enough  to  influence,  very 
strongly,  the  importation  and  exportation  of  other  goods, 
because  so  slight  a  rise  causes  shipment  of  gold  (which, 
because  of  its  great  value  in  small  bulk,  is  inexpensive 
in  proportion  to  value,  to  ship) }  It  is  quite  likely,  then, 
that  excess  buying  of  Americans  from  abroad,  will  not 
be  checked  or  give  rise  to  corresponding  purchases  by 
foreigners  from  this  country,  until  a  flow  of  gold  has 
changed  relative  price  levels. 

»  Cf.  Ch.  VI  (of  Part  I),  §  g. 


I20  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

Payments  for  freight,  banking,  and  other  services 
affect  exchange  in  the  same  way  as  do  payments  for 
commodities.  For  example,  payments  for  ship  trans- 
portation services  are  supposedly  made  where  these 
services  can  be  secured  most  cheaply.  Thus,  a  maritime 
nation  like  Great  Britain  could  sell  to  us  the  services 
of  her  ships;  and  the  resulting  flow  of  money  towards 
Great  Britain  and  higher  prices  there  of  various  goods, 
would  give  rise  to  their  purchase  of  such  goods,  e.g. 
wheat,  from  us.  Great  Britain  might  be  said  to  export 
transportation,  banking,  and  other  services,  and  to 
import  food. 

Summarizing  the  conclusions  of  this  section  and  com- 
bining them  with  previous  conclusions,  we  may  assert 
(i)  that  the  rate  of  exchange  in  one  country  on  another 
depends  upon  the  supply  of  and  the  demand  for  drafts ; 
(2)  that  the  supply  of  and  demand  for  drafts  depends  on 
tlie  direction  of  obligations  and  other  occasions  for  mak- 
ing payments  between  the  countries ;  (3)  that  the  direc- 
tion of  obHgations,  etc.,  depends  largely  upon  the  surplus 
of  commodities  and  services  purchased  by  one  country 
of  another ;  and  (4)  that  the  surplus  of  commodities  and 
services  purchased  by  one  country  of  another  depends 
upon  the  relative  prices  of  those  commodities  andser-. 
vices  in  (or  as  sold  by)  the  countries  concerned. 

§7 

The  Long  Run  Effect  of  International  Investments  upon 
the  Rate  of  Exchange  and  the  Flow  of  Money 

We  have  next  to  examine  the  long  run  effect  of  inter- 
national (or  interterritorial)  investments  upon  the  rate 
of  exchange  and  upon  the  flow  of  money.     If,  for  example, 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     121 

Englishmen  invest  in  the  United  States,  if  we  borrow  of 
them  or  sell  securities  and  other  property  to  them,  what 
is  the  immediate  effect?  It  is  to  increase  the  supply, 
here,  of  drafts  on  England,  or  decrease  the  demand  for 
such  drafts,^  and  so  to  lower  the  rate  of  exchange  on 
England;  and  to  increase  the  demand  in  England  for 
drafts  on  the  United  States,  raising  there  the  rate  of 
exchange  on  us  (though  this  fact  is  obscured  by  the  cus- 
tom of  quoting  the  rate  in  England,  as  here,  in  American 
money).  Then  it  becomes  worth  while  for  American 
banks  to  import  and  for  English  banks  to  export,  gold. 
As  a  second  consequence,  therefore,  gold  flows  from 
England  to  the  United  States.  Since  much  of  this  gold, 
because  of  the  laws  of  interflow  between  gold  bullion  and 
gold  coin  2  is  a  subtraction  from  English  money  and  an 
addition  to  American  money,  prices  will  tend  to  fall  in 
England  and  will  tend  to  rise  in  the  United  States. 
Then  it  will  become  profitable  for  us  to  buy  more  goods 
in  England,  while  England  will  buy  less  goods  of  us.  As  a 
next  consequence,  the  obligations  from  us  to  them  will 
be  in  excess,  and  the  rate  of  exchange  on  London  will 
rise.  Therefore,  gold  will  be  shipped  back  again  in 
return  for  other  goods.^  This  return  flow  must  continue 
until  English  and  American  prices  (supposing  no  new 
influences  to  intervene)  are  in  about  the  same  relation  as 
before  the  lending  or  investing  began.  That  means  that 
in  each  country  the  quantity  of  money  must  be  in  about 
the  same  relation  as  before  to  the  quantity  of  goods. 
Speaking  roughly,  we  may  say  that  the  invested  money 
flows  back  for  goods,  or  that  what  is  really  invested  is 

1  See  Ch.  IV  (of  Part  I),  §  2. 

2  See  Ch.  I  (of  Part  I),  §  7. 

»  See  Taussig,  Principles  of  Economics,  pp.  468-471. 


122  THE  EXCHANGE  MECHA>ftSM  OF  COMMERCE 

usable  capital.  If  Englishmen  invest  in  the  securities 
of  a  new  American  railroad,  what  we  really  get  from 
England  may  be  steel  rails,  engines,  etc.,  or  cloth,  coal, 
and  other  goods  to  be  consumed  by  us  while  we  are  mak- 
ing tlie  rails  and  engines.  International  lending  and 
investing  is  most  decidedly  a  lending  and  investing  of 
capital  wealth  in  such  forms  as  are  here  suggested,  and 
not  merely  a  flow  of  money. 

Foreign  investments  here  may,  in  fact,  take  largely 
the  form  of  usable  capital,  without  the  intermediation  of 
these  stages  of  inflow  and  outflow  of  money.  The  fall 
in  the  rate  of  exchange  on  foreign  countries,  consequent 
on  such  investments,  itself  tends  to  make  foreign  goods 
slightly  cheaper  in  terms  of  American  money  and  so  to 
encourage,  somewhat,  importation  of  usable  capital, 
even  before  the  tendency  to  importation  is  accentuated 
by  the  change  in  relative  price  levels.^  And  if  gold  does 
flow  in  to  some  extent,  the  tendency  for  it  to  flow  out 
for  other  goods  may  show  itself  so  quickly  that,  aside 
from  the  first  slight  inflow,  the  purchase  of  capital  goods 
abroad  keeps  pace  with  the  investments  made  by 
foreigners  here.  In  effect,  the  foreign  investors  send 
us,  perhaps  almost  at  once,  capital  other  than  money. 

§8 

The  Long  Run  Effect  of  Various  Other  Payments  from 
One  Country  to  Another 

The  third  group  of  purposes  for  which  bills  of  exchange 
and  money  are  sent  from  country  to  country,  is  to  pay 
interest,  dividends,  and  profits  on  investments,  to  send 
remittances  to  persons  travelling  abroad,  and  to  send 

»  Cf.  §  6  of  this  chapter  (V  of  Part  I). 


RATE  OF  EXCHANGE  AND  flOW  OF  SPPCIE     123 

remittances  to  the  families  of  immigrants.  We  have 
just  seen  that,  when  foreigners  invest  here,  such  invest- 
ment, in  the  long  run,  is  an  investment  of  consumable 
goods,  or  of  the  machinery  of  production,  or  both. 
In  the  long  run,  what  flows  here  is  goods  rather  than 
money.  After  a  time,  interest  is  earned  on  the  bonds 
foreign  investors  have  purchased,  dividends  are  declared 
on  the  stock,  etc.  Having  secured  the  use  of  for^i^n 
capital,  we  must  pay  interest  on  it.  There  arises  then 
a  demand  for  exchange  on  foreign  countries  in  order  to 
pay  these  investors  their  profits.  This  demand  makes 
exchange  on  foreign  countries  high  (while  on  us  it  is 
low),  and  it  becomes  worth  while  for  gold  to  be  shipped 
from  us  to  them.  The  same  kind  of  result  occurs  if 
and  when  the  invested  capital  is  itself  repaid  (i.e.  if 
American  investors  buy  back  from  foreigners  American 
land,  securities,  etc.).  Consequently  foreign  prices 
tend  to  rise  and  ours  to  fall.  Therefore,  foreigners  buy 
more  goods  of  us  than  previously,  and  the  money  flows, 
chiefly,^  back  here.  In  the  last  analysis  the  interest 
and  dividends  received  are  practically  all  in  the  form  of 
food,  raw  material,  manufactured  goods,  etc.,  and  are 
not  merely  money. 

So,  in  the  last  analysis,  remittances  to  Americans 
travelling  abroad  and  to  the  families  of  immigrants, 
have  the  same  result.  Our  countrymen  travelHng  abroad 
receive  from  home,  in  the  long  run,  not  money,  but 
goods.     Of  course  they  may  purchase  chiefly  European 

^  Not,  perhaps,  entirely,  because  the  somewhat  larger  amount  of  goods  in 
foreign  countries,  consequent  on  the  flow  back  to  us,  for  goods,  of  the  interest 
and  dividends  money,  may  require  a  little  more  money  to  be  circulated.  But 
the  rapidity  of  circulation  of  money  and  the  fact  that  it  is  the  basis  for  bank 
credit  circulating  even  more  rapidly,  would  seem  to  signify  that  a  very  large 
increase  in  the  quantity  of  goods  abroad  would  call  for  but  a  slight  increase  in 
money. 


124  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

goods,  but,  if  so,  they  thereby  put  some  Europeans  in  a 
position  to  get  American  goods.  In  the  long  run,  it  is 
chiefly  goods  other  than  money  which  flow  in  trade. 

§9 

Summary 

Though  the  use  of  bills  of  exchange  obviates,  to  a  large 
degree,  the  necessity  of  shipping  money  or  gold,  never- 
theless, as  we  have  seen,. balances  must  be  thus  settled. 
A  continuous  balance  of  obligations  in  one  direction  will 
cause  gold  to  be  shipped,  by  affecting  the  rate  of  exchange. 
It  will  become  cheaper  to  settle  indebtedness  by  shipping 
gold,  and  the  exportation  or  importation  of  gold  may  be 
undertaken  for  profit.  A  high  rate  of  exchange,  here,  on 
any  country,  will  cause  shipments  of  gold  to  that  country ; 
a  low  rate  will  cause  importations  of  gold  from  that 
country.  Exportation  of  gold  to  any  country  will  tend 
to  keep  down  the  price  of  drafts  on  that  country  by 
decreasing  the  demand  for  them  (debts  being  settled  by 
gold)  and  by  increasing  the  supply  of  them  (drafts  being 
drawn  on  consignees  when  gold  is  shipped  for  profit). 
Importation  of  gold  from  any  country  will,  analogously, 
tend  to  keep  up  the  price  of  drafts  on  that  country  by 
decreasing  the  supply  of  drafts  (gold  being  imported 
instead  of  drafts  being  drawn),  and  by  increasing  the 
demand  for  them  (to  purchase  foreign  gold  imported  for 
profit).  The  rate  of  exchange  can,  therefore,  go  above 
or  below  par  by  only  about  the  cost  (with  perhaps  a 
reasonable  profit)  of  shipping  specie.  But  at  a  time  o^ 
stringency,  when  most  business  men  in  a  country  desire 
to  secure  funds  as  quickly  as  possible,  the  rate  may  go 
somewhat  lower  than  what  would  usually  be  the  gold 
importing  point. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     125 

In  the  long  run,  specie  tends  to  flow  to  those  places 
where  other  desired  goods  are  cheapest  (and  specie, 
therefore,  of  most  value  or  purchasing  power  in  com- 
parison with  those  goods),  and  from  places  where  goods 
other  than  money  are  high.  So  lending  and  investing 
between  countries  is  really,  in  the  main,  a  lending  and 
investing  of  capital  goods  rather  than  money ;  for  the 
flow  of  money  changes  the  relative  levels  of  prices  of  the 
countries  concerned,  and  brings  about  a  reverse  flow. 
The  same  principle  appHes  to  the  payments  of  interest 
and  dividends,  remittances  to  persons  abroad,  etc.  The 
use  of  bills  of  exchange  and  money  complicates  these 
business  relations  of  countries  and  territories;  but  it 
does  not  change  the  essential  fact  that  trading,  lending, 
investing,  and  profiting  involve,  in  the  last  analysis, 
capital  and  consumable  goods  rather  than  money. 
Money  (as  well  as  bills  of  exchange,  etc.)  is  a  part  of  our 
machiner}^  of  production,  but  only  a  part,  and  it  is  as  a 
part  of  this  machinery  that  it  is  of  use  in  international 
and  interterritorial  business  relations. 


FxjRTHER  Considerations  Regarding  the  Rate  of 
Exchange 

§1 

The  Price  of  Long  Drafts  Determined  in  p^ri  by  the  Rt^ 
of  Interest  or  Discount 

The  price,  here,  of  bills  of  exchange  on  any  given 
country,  at  a  given  time,  may  be^regarded  as  being  made 
up  chiefly  of  two  factors.  These  are,  the  rate  of  Interest  Cj  / 
or  discount,  and  the  pure  rate  of  exchange.  The  pure  (^'^ 
rate  of  exchange  is  the  rate  on  demand  or  sight  drafts. 
As  to  these  there  is  no  element  of  time  except,  of  course, 
the  time  required  for  the  carriage  of  the  drafts  from  the 
one  country  to  the  other.  Ignoring  the  sHght  interest 
thus  involved,  some  -^V  of  the  yearly  rate,  we  may  say 
that  the  rate  of  exchange  on  sight  drafts  is  pure  exchange. 
It  is  the  rate  of  exchange  on  sight  drafts,  which  we  have 
in  mind  when  we  say  that  exchange  can  ordinarily  fluc- 
tua^_only.between  the  specie  points  or  shipping  Kniits. 

But  with  other  drafts,  the  rate  of  interest  or  discount 
is  an  important  fact  to  consider.  Many  of  these  drafts 
are  drawn  to  run  for  periods  of  60,  90,  and  even  120 
days  after  sight.  Since  payment  on  such  a  draft  can- 
not be  required  before  maturity,  the  investing  pur- 
chaser of  the  draft  is  in  the  position  of  a  lender  or  in- 
vestor until  then,  unless,  of  course,  he  sells  to  another. 
As  a  lender  or  investor,  he  will  wish  to  get  interest  on  his 
investment,  and  since  the  amount  he  is  to  receive  at 

126 


flM^THER  CONSIDERATIONS  ON  EXCHANGE    127 

maturity  is  definitely  fixed,  he  can  secure  interest  only 
by  paying  somewhat  less  than  this  amount  when  he  buys 
the  draft.  In  short,  the  investing  purchaser  must  dis- 
count the  draft  for  the  time  it  has  to  run,  and  the  amount 
of  this  discount  will  depend  upon  the  rate  of  discount  or 
the  rate  of  interest.  Since  the  investing  purchaser  is 
sure  to  discount  the  draft,  the  exchange  bank  which  buys 
it  in  the  first  instance,  intending  to  have  it  sold  in  the 
exchange  market,  must  also  discount  it.  Thus,  even 
if  exchange  here,  on  England,  were  above  par,  say 
$488.65  =  £100,  a  draft  for  £100  having  some  time  to 
run  might,  because  of  the  element  of  time,  be  selling 
for  $482. 

It  may  be  noted  in  passing  that  an  importer  can,  in 
effect,  secure  a  cash  discount  on  his  purchases  by  remit- 
ting a  60-day  or  90-day  draft.  Suppose  he  has  pur- 
chased £100  worth  of  goods  in  London,  payment  to  be 
made  in  90  days.  If  it  is  agreed  that  he  shall  remit,  he 
can,  just  before  maturity  of  the  debt,  buy  a  draft  and 
send  it.  But  he  can  also,  if  he  prefers,  buy  immediately 
a  draft  payable  in  90  days.  If  he  does  this,  he  will  get 
the  draft  at  a  discount.  His  goods  will  cost  him  less 
because  he  is  prepared  to  pay  at  once.  As  a  matter  of 
fact,  banks  frequently  sell  such  time  drafts  to  importers. 

§2 

How  Long  Drafts  on  Foreign  Countries  are  Held  as  Invest- 
ments by  American  Banks 

The  fact  that  many  drafts  run  for  periods  of  several 
months  and,  being  purchased  at  a  discount,  yield  interest 
to  the  holders  of  them,  makes  these  drafts  desirable  as 
short  term  investments.     Sometimes   the  bank  which 


128  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

originally  purchases  long  drafts,  in  the  *' drawing" 
country,  prefers  to  realize  this  interest,  rather  than  to 
have  such  drafts  sold  at  once  in  the  discount  market  of 
the  *' accepting"  country.  Let  us  suppose  that  for  a 
time  the  discount  rate  on  safe  drafts,  in  the  German 
market,  is  7  per  cent,  while  conditions  of  business  in  the 
United  States  are  such  that  American  banks  cannot 
earn  more  than  about  5  per  cent  on  their  capital  used 
at  home.  Under  these  conditions,  an  American  bank 
purchasing  drafts  on  Qcrn^f iiy,  having  some  time  to  run, 
would  probably  not  send  them  to  Germany  for  imme- 
diate discount  at  the  comparatively  high  rates  there 
prevailing ;  but  would  be  more  apt  to  hold  them  in  its 
own  vaults,  or  have  them  held  for  its  account  by  its 
German  correspondent,  until  maturity  or  near  maturity, 
in  order  to  reahze  a  larger  sum. 

Before  describing  the  method  of  procedure  commonly 
followed  when  drafts  on  foreign  countries  are  held  in  its 
own  vaults  for  investment  by  an  American  bank,  it  is 
essential  to  note  that  bills  of  exchange  or  drafts  used  in 
international  trade,  are  generally  made  out  in  duplicate, 
the  different  copies  being  known  as  firsts  and  seconds. 
This  has  long  been  the  custom  in  such  trade,  as  a  safe- 
guard against  possible  loss  or  miscarriage  of  one  of  the 
drafts.  Whichever  draft  first  reaches  its  destination  is 
presented  for  acceptance,  and  when  it  is  paid  the  debt 
is  cancelled.  Extra  copies  of  bills  of  lading  and  other 
documents  may  also  be  made. 

Consider  now  the  procedure  which  may  be  followed  by 
the  investing  American  bank  in  holding  the  drafts  on 
Germany.^    On  the  day  of  purchase  by  an  American 

1  Described  in  Margraff,  International  Exchange,  Chicago  (Fergus  Printing 
Co.),  1903,  p.  61. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    129 

bank  of  drafts  on  German  banks  or  merchants,  the 
'^firsts"  of  these  drafts  or  bills  of  exchange  are  not 
indorsed  by  the  American  bank  to  the  order  of  its 
German  correspondent,  as  would  be  done  if  the  drafts 
were  to  be  sent  over  for  immediate  discount  and  credit 
or  for  holding  abroad  subject  to  cable  order.  On  the 
contrary,  there  are  written  on  the  faces  of  these  firsts 
the  words  ''for  acceptance  only."  Then  the  German 
correspondent  bank  to  which  the  drafts  are  forwarded, 
is  requested  to  have  them  "accepted,"  and  to  hold  them 
subject  to  the  call  of  the  seconds  properly  indorsed  by 
the  American  bank.  Any  dupHcate  documents,  such  as 
dupUcate  bills  of  lading,  attached  to  the  seconds,  are 
detached  and  sent  to  the  German  correspondent  bank, 
which  is  instructed  to  turn  these  documents  over  to 
the  drawees  provided  the  latter  accept  the  drafts.  The 
seconds,  clean  of  all  other  papers,  are  kept  by  the  invest- 
ing American  bank.  On  the  face  of  each  of  these  seconds 
is  written:  "Accepted  firsts  held  by — — ,"  giving  the 
name  of  the  bank  to  which  the  firsts  were  sent.  The 
American  bank  gets  as  profit  the  difference  between  the 
discounted  value  paid  for  the  drafts  and  the  amount 
realizable  from  them  at  maturity,  minus  the  corre- 
spondent's commission. 

When  the  date  of  maturity  approaches,  the  American 
bank  will  indorse  the  seconds,  presumably  to  the  above 
described  correspondent  bank,  and  forward  them  to  it  for 
credit.  As  a  matter  of  fact,  the  American  bank  need  not, 
if  it  prefers  otherwise,  send  the  indorsed  seconds  to  the 
foreign  bank  which  holds  the  firsts.  The  seconds  can, 
if  occasion  requires,  be  indorsed  to  any  bank,  for  the 
firsts  are  held  subject  to  the  call  of  the  indorsed  seconds, 
and  must  be  handed  over  (or  credited,  as  the  case  may  be) 

K 


I30  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

on  presentation  of  these  indorsed  seconds.^  The  two 
together  constitute  a  completed  bill. 

The  drafts  may  be  so  indorsed  and  forwarded  to  the 
correspondent  bank  for  discount  and  credit  at  any  time 
when  rates  of  discount  make  it  seem  profitable  to  send 
them.2  They  are  not  necessarily  held  until  maturity. 
But,  in  any  case,  the  amount  realized  (minus  commis- 
sion) is  placed  to  the  American  bank's  credit,  and  it  can 
then  sell  drafts  on  this  credit.  Of  course,  the  investing 
bank  takes  some  risk  of  fluctuations  in  the  rate  of  ex- 
change. If  the  rate  falls,  the  bank  will  get  somewhat 
less  when  it  sells  its  drafts  on  this  credit.  If,  on  the 
other  hand,  the  rate  of  exchange  on  Germany  was  low 
when  the  American  bank  bought  the  drafts  for  invest- 
ment, so  that  they  could  be  purchased  more  cheaply, 
and  is  high  when  the  bank  is  ready  to  sell  its  own  drafts 
on  the  credit  secured  (at  maturity  or  before),  then  the 
bank  will  realize  an  additional  profit. 

But  the  American  bank,  even  if  desiring  to  avail  itself 
of  higher  interest  rates  existing  temporarily  in  Germany, 
will  often  prefer  to  indorse  the  drafts  it  has  purchased 
to  its  German  correspondent,  and  have  them  held  by  the 
latter,  after  acceptance,  subject  to  instructions  by  cable. 
An  advantage  of  this  method  lies  in  the  possibility  of 
immediate  sale  at  any  time  before  maturity  if  low  dis- 
count rates  make  it  desirable  to  have  the  drafts  sold.  If 
to  have  them  sold  does  not  appear  to  be  profitable,  they 
can  be  retained  till  maturity  for  account  of  the  remitting 
bank. 

1  Margraff,  International  Exchange,  p.  65.  '  Ibid.,  p.  63. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    131 

§3 

Influence  on  the  Price  of  Long  Drafts,  of  Interest  Rate 
in  Drawing  Country  and  of  Interest  Rate  in  Country 
Drawn  Upon 

We  have  seen  that  the  prices  of  bills  of  exchange,  other 
than  sight  bills,  depend  upon  the  rate  of  interest.  We 
have  also  seen  that  bills  of  exchange  involve  two  trading 
countries ;  and  in  the  previous  section  attention  has  been 
called  to  the  fact  that  the  rate  of  interest  in  one  such 
country  may  be  different  from  the  rate  of  interest  in  the 
other.  Which  of  the  two  rates  of  interest  or  discount 
will,  in  such  a  case,  determine  the  price  of  a  bill  of 
exchange  drawn  in  one  country  on  the  other  ?  ^ 

In  the  first  place,  let  us  suppose  interest  to  be  com- 
paratively high  in  the  country  where  the  bill  in  question  is 
drawn,  say  the  United  States,  and  comparatively  low  in 
the  country  on  which  it  is  drawn,  say  England.  On 
this  assumption,  the  amount  of  the  discount,  and, 
therefore,  the  price  of  the  draft,  will  depend  on  the  rate 
of  interest  or  discount  in  the  country  on  which  the 
draft  is  drawn,  viz.,  England.  For  if  the  rate  of  discount 
in  England  is  very  low,  then  the  draft  will  sell,  in  England, 
for  a  high  price,  that  is,  for  a  price  comparatively  near 
the  maturity  value.  And  since  it  will  thus  sell  in  the 
EngHsh  discount  market  for  a  high  price,  therefore  the 
American  bank  which  first  allows  cash  for  it  to  a  mer- 
cantile or  other  estabHshment,  can  afford  to  pay  a  high 
price  for  the  draft.  The  American  bank  which  buys  the 
draft  does  not  need  to  wait  until  maturity  to  realize  on  it, 
but  can  have  it  discounted  immediately  on  its  arrival 

^  The  reasoning  here  followed  is  that  of  Goschen,  The  Theory  of  the  Foreign 
Exchanges,  third  edition,  London  (Efl&ngham  Wilson),  1896,  p.  137. 


^^ 


132  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

at  London.  The  American  bank  does  not  need  to  lose, 
for  a  long  period,  the  use  of  its  capital.  As  a  conse- 
quence, competition  among  American  banks  will  force 
up  the  price  of  such  drafts  to  somewhere  near  what  they 
will  bring  in  the  English  discount  market.  Our  conclu- 
\  sion  must  be  that  if  the  interest  rate  in  the  country- 
drawn  upon  is  the  lower,  this  interest  rate  determines  the 
price  of  long  drafts  in  the  drawing  country  also. 

But  suppose,  on  the  other  hand,  that  the  rate  of  inter- 
est is  higher  in  the  country  drawn  upon,  say  England, 
than  in  the  drawing  country,  the  United  States.  On  this 
hypothesis,  a  draft  on  England  would  be  discounted  in 
England  at  a  comparatively  high  rate,  that  is,  would 
bring  a  relatively  low  price.  Would  its  price  be  equally 
low  in  the  drawing  country?  Certainly  if  the  pur- 
chasing bank  in  the  United  States  intended  to  send  the 
draft  at  once  abroad  for  discount,  such  a  bank  could  not 
afford  to  pay  more.  To  do  so  would  mean  a  definite 
loss.  But,  on  our  present  hypothesis,  a  draft  purchased 
at  the  low  price  based  on  the  discount  rate  in  England, 
will  yield  a  greater  return  on  the  investment  than  the 
prevailing  rate  of  interest  in  the  United  States,  the  draw- 
ing country.  Competition  among  banks  in  the  drawing 
country,  desiring  to  invest  in  such  bills  of  exchange,  may, 
therefore,  raise  the  price  of  the  draft  slightly  above  its 
value  in  the  country  drawn  upon ;  for  even  then  it  will 
bring  a  larger  return  by  way  of  interest  than  is  being 
realized  generally  in  the  drawing  country.  The  seller 
of  the  draft  may  hope  to  get  for  it  a  Httle  more  than  the 
price  it  would  bring  in  England,  while  the  purchasing 
bank  realizes  more  than  the  rate  of  interest  in  the  United 
States,  enough  more  to  induce  this  bank  to  buy  and  hold 
the  draft  as  an  investment,  or  have  it  held  for  its  account 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    133 

abroad.  When,  therefore,  the  rate  of  interest  is  lower 
in  the  drawing  country,  the  price  of  the  draft  will  be 
determined,  at  least  in  small  part,  by  that  rate  of  interest. 
It  should  be  added  that  if  conditions  change  during  the 
life  of  a  draft,  so  that  interest  is  lower  in  England,  such 
a  draft  held  here  as  an  investment  is  likely  to  be  sent 
there  for  immediate  discount  at  the  high  price  realizable. 
As  a  matter  of  fact,  the  discount  rate  in  London,  as 
also  in  other  great  European  centres,  is  almost  always 
lower  than  in  New  York.  The  usual  rule,  therefore,  is 
for  American  banks  to  have  their  drafts  on  England 
discounted  there  at  once.  Their  capital  can  be  more 
profitably  invested  at  home  than  in  holding  long  drafts 
on  English  debtors.  On  the  other  hand,  Enghsh  banks 
do  not  have  long  drafts  which  they  buy  on  Americans, 
discounted  in  the  United  States.  The  absence,  here,  of 
a  rediscount  market,  makes  it  practically  impossible  for 
them  to  do  this,  though  the  usually  higher  rates  of  dis- 
count prevailing  in  the  United  States  might,  in  any  case, 
disincline  them  to  have  such  drafts  sold  on  this  side. 
There  are,  in  practice,  very  few  long  bills  drawn  upon 
the  United  States,  and  such  long  bills  as  are  drawn  upon 
this  country  are  usually  held  till  maturity,  for  account 
of  the  foreign  remitting  banks,  by  their  American 
correspondents.^ 

§4  ^^ 

How  and  Why  the  Bank  Discount  Rate  Affects  the  Price  oj 
Demand  Drafts  and  the  Flow  of  Specie 

Changes  in  the  relative  rates  of  interest  in  different 
countries  affect,  temporarily,  rates  of  exchange  and  the 
flow  of  specie;   though  such  changes  in  relative  rates 

1  See  Ch.  Ill  (of  Part  I),  §  8. 


134  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  interest  do  not  permanently  affect  the  international 
distribution  of  specie,  independently  of  comparative  price 
levels.  For  example,  much  is  said  of  the  influence  on 
the  rate  of  exchange  and  on  the  flow  of  gold,  of  the  Bank 
of  England  discount  rate.  If  the  Bank  of  England, 
because  of  too  rapidly  expanding  loans  or  because  of 
depletion  of  reserves,  raises  its  rate  of  discount,  being 
followed  in  this  move  by  the  other  English  banks,  its 
doing  so  has  a  tendency  to  lower  the  rate  of  exchange 
in  England  on  the  United  States  and  other  countries, 
and  to  raise  the  rate  in  the  United  States  and  elsewhere 
on  England.  It  has  this  effect  because  the  increased 
interest  in  England  tempts  to  investment  there  rather 
than  in  the  United  States.  English  banks  are  more 
likely  to  invest  current  funds  at  home,  and  may  even  draw 
on  debtor  banks  in  the  United  States  and  other  countries. 
American  and  other  banks  may  be  tempted  to  make 
short  term  loans  in  England  or  to  hold  or  have  held  until 
maturity,  long  bills  which  they  would  otherwise  have 
immediately  discounted.  This  holding  of  drafts  until 
maturity  will  compel  them  to  buy  more  drafts  on  Eng- 
land than  otherwise  would  be  necessary,  in  order  to 
maintain  their  usual  balances.  The  general  result  of  a 
high  discount  rate  in  England  is,  therefore,  a  high  rate 
of  exchange  on  and  a  flow  of  gold  to  England.^  Similarly, 
a  sharp  rise  in  the  discount  rate  in  New  York  would  tend 
to  produce  elsewhere  a  high  rate  of  exchange  on  New 
York,  and  would  tend  to  cause  a  flow  of  gold  to  New 
York. 

But  we  have  seen  that  the  flow  of  gold  from  country  to 
country  is  determined  by  comparative  prices  of  goods. 
If,  because  of  a  high  discount  rate  in  England,  gold  flows 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  third  edition,  pp.  129-140. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    135 

to  England  in  large  quantities,  so  that  prices  rise  there 
and  fall  here ;  then  England  becomes  a  good  place  to 
sell  to,  and  the  United  States  (and  other  countries)  by 
comparison  a  good  place  to  buy  from.  The  gold  will 
therefore  flow  back  for  goods  until  prices  are,  relatively, 
what  they  were  before.  Americans,  or  American  banks, 
who  have  invested  in  England  because  of  the  high  rates- 
of  interest  there,  will  have  invested,  in  fact,  not  money 
but  other  capital. 

But  at  this  point  a  qualification  must  be  made,  based    fs 
on  the  fact  that  the  bank  rate  of  discount  influences,  in- 
directly, the  prices  of  goods.     The  bank  discount  rate  in-  "^ 
fluences  prices  by  affecting  credit.     It  was  pointed  out,  in     1 
Chapter  II  (of  Part  I)  ,^  that  the  general  level  of  prices  in 
a  modern  industrial  and  commercial  community  or  coun- 
try is  determined  not  alone  by  the  quantity  of  money  and 
its  velocity  of  circulation  and  by  the  volume  of  trade,  but 
also  by  the  amount  and  velocity  of  bank  credit.    The 
relationship  set  forth  was  expressed  in  the  equation, 

MV  +  M'V'  ^  pq-{-  p'q'  +  etc. 

Ordinarily,  it  was  shown,  M'  maintains  a  fairly  constant 
rather  than  a  violently  fluctuating  ratio  to  M.  The 
total  amount  of  this  M'  or  bank  credit  in  a  community 
will  depend  partly  on  the  business  needs  and  customs 
of  that  community,  but  partly,  also,  on  the  quantity  of 
such  credit  which  the  banks  can  safely  keep  in  circula- 
tion with  a  given  support  of  cash  reserves.  If  lack  of 
confidence  depletes  these  reserves,  or  if  banks  have 
expanded  their  credit  too  far  for  their  reserves  safely  to 
support,  contraction  of  this  credit  is  necessary.  The 
banks  discourage  borrowing,  and  so  decrease  the  amount 

»§6. 


136  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  circulating  bank  credit  by  charging  higher  interest 
to  borrowers,  i.e.  by  raising  their  rates  of  discount. 

Suppose,  then,  that  because  of  a  condition  of  business 
distrust  and  comparatively  small  reserves,  the  Bank  of 
England  and  other  English  banks  raise  their  rates  of 
discount.  As  a  consequence,  there  is  a  fall  in  the  rate 
of  exchange  on  New  York,  and,  in  New  York,  a  rise 
in  the  rate  on  London.  There  follows  a  flow  of  gold  to 
London  and  the  bank  reserves  there  are  replenished. 
But  this  gold  does  not,  at  least  for  the  time  being,  raise 
English  prices  and  result  in  a  corresponding  flow  of  gold 
back  to  the  United  States  (and  other  countries) ;  for 
the  increase  of  the  bank  charges  on  loans  discourages 
borrowing  from  banks,  and  so  tends  to  decrease  M'. 
In  the  equation,  MV  +  M'V  =  pq  +  p'q'  +  etc.,  for 
England,  the  p^s  may  not  be  at  all  increased  or  may  even 
be  decreased.^  Only  when  bank  credit,  in  England,  is 
again  allowed  to  expand,  will  the  full  effect  of  the  inflow 
of  gold  be  felt  in  higher  prices.  So  long  as  high  discount 
rates  keep  the  total  of  circulating  bank  credit  in  England 
less  than  before  in  relation  to  money,  the  inflow  of  gold 
does  not  so  much  raise  prices  as  substitute  itself  for  bank 
credit.     Hence,  gold  will  not  flow  out  again,  for  goods.^ 

1  Cf.  Goschen,  The  Theory  of  the  Foreign  Exchanges,  p.  129,  where  this  idea, 
though  not  developed,  seems  to  be  implied. 

'  Just  before  the  outbreak  of  the  European  war  now  (August,  1914)  in 
progress,  the  efforts  of  European  investors  to  dispose  of  securities  for  gold  and 
the  closing  of  the  principal  bourses  of  the  world,  caused  a  flood  of  sales  on  the 
New  York  stock  exchange,  large  piirchases  of  these  securities  by  Americans,  and 
an  unusually  strong  tendency  for  gold  to  flow  abroad.  In  view  of  the  sudden- 
ness and  violence  of  the  movement,  it  was  perhaps  not  unwise  that  the  New 
York  stock  exchange  should  be  temporarily  closed  (see  New  York  World, 
August  I,  1914)  and  that  the  sale  of  securities  here  by  foreigners  should  thus 
be  made  diflScult.  It  is  true  that  the  flow  of  gold  abroad  (and  we  are  not  here 
concerned  with  any  other  reason  for  the  closing  of  the  exchange)  is  not  ordinarily 
a  proper  cause  for  alarm,  can  be  checked  by  a  rise  in  bank  discount  rates  if  such 
a  check  is  necessary,  and  will  in  any  case,  if  long  continued,  give  rise  to  a  re- 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    137 

f'is 


Effect  of  a  Panic  in  One  Country  on  Conditions  in  Other 
Countries 

Since  prices  and  interest  rates  in  different  countries 
are  related,  a  panic  in  one  country  cannot  usually  be 
altogether  without  effect  on  other  countries  having  close 
commercial  relations  with  it/  though  these  other  coun- 
tries may  not  be  affected  acutely.  When,  for  any  reason, 
in  a  country  of  large  commercial  importance,  business 
confidence  gives  place  to  acute  distrust,  and  the  banks, 
with  reserves  depleted  or  fearing  that  the  reserves  will  be 
depleted,  raise  their  discount  rates,  their  action  will 
affect  discount  rates  in  commercially  related  countries. 
The  strain  on  the  bank  reserves  of  the  first  country,  and 
the  rise  of  the  discount  or  interest  rate,  tends  to  draw 
gold  from  other  countries. 

This  will  tend  to  deplete  the  bank  reserves  of  those 
countries  in  relation  to  circulating  bank  credit.  Either 
the  gold  will  come  directly  from  these  bank  reserves  as 
when  it  is  drawn  from  the  great  central  banks  of  Europe 
for  export,  or  it  will  come  indirectly  but  just  as  surely 
from  bank  reserves,  as  when  gold  is  bought  for  export 
from  a  United  States  sub  treasury  and  is  paid  for  by 
lawful  money  which  might  otherwise  be  used  as  reserves.^ 

turn  flow.  Yet  so  unprecedented  a  movement  as  the  recent  one  here  under 
discussion,  might  conceivably,  if  met  only  by  a  rise  in  the  discount  rate  (which 
would  also  have  to  be  great  and  sudden),  dangerously  and,  considering  the 
probable  temporary  nature  of  the  crisis,  unnecessarily  disturb  credit  conditions. 

^  Cf.  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  igii, 
p.  267. 

'  Even  if  the  gold  is  purchased  with  bank  credit,  the  reserves  become  smaller 
in  proportion  as  compared  with  the  total  amount  of  such  credit ;  and  they  tend 
(since,  as  we  have  seen  —  Ch.  II,  §  s  —  business  men  keep  some  relation  between 
their  bank  accounts  and  cash  assets,  and  will  draw  out  cash  if  the  latter  become 
relatively  too  small)  to  become  absolutely  smaller. 


138  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  conclusion  is  that  in  any  case  the  banks  in  those 
countries  from  which  the  gold  is  drawn,  will  also  have 
occasion  to  raise,  somewhat,  their  discount  rates,  in  order 
to  keep  their  reserves  and  their  deposits  (and  notes) 
in  proper  relation  to  each  other.  And  if  contraction  of 
credit  causes  a  fall  of  prices  in  one  country,  the  mitigated 
effect  of  this,  at  least,  must  spread  to  other  countries. 
It  does  not  follow  that  a  severe  panic  in  one  country 
must  be  accompanied  by  or  succeeded  by  a  correspond- 
ingly severe  panic  in  others ;  but  only  that  in  each  of 
a  group  of  commercially  related  countries  there  will 
be  practically  simultaneous  rises  in  price  levels,  nearly 
simultaneous  high  prices  and  high  discount  (interest) 
rates,  and  substantially  simultaneous  decline.  The 
goodness  of  its  banking  system  (and  other  facts),  may 
make  the  changes  more  gradual  and  less  severe  in  one 
country  than  in  others,  but  is  not  likely  to  prevent  the 
changes  altogether. 

§6 

Exchange  between  Two  Countries  when  One  has  a  Gold 
and  the  Other  a  Silver  Standard 

An  excess  production  of  gold  in  any  country  raises 
prices  there  compared  to  prices  in  other  countries, 
encourages  buying  goods  in  other  countries,  and  there- 
fore raises  the  rate  of  exchange  on  other  countries. 
Export  of  gold  follows.  The  introduction  of  a  cheaper 
standard  of  value  has  the  same  effect.  A  large  coinage 
of  cheaper  money,  e.g.  silver  at  a  ratio  of  i6  to  i  (which 
would  greatly  overvalue  silver  and  lead  to  a  large  coin- 
age), would  increase  M.  Prices  would  rise  and  the  value 
of  money  would  fall.  Goods  would  therefore  be  pur- 
chased abroad.    The  rate  of  exchange  on  foreign  coun- 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    139 

tries  would  rise  and  gold  would  be  exported.  As  long 
as  the  silver  and  gold  both  circulated  and  were  generally 
acceptable  for  goods  at  the  legal  ratio,  the  rate  of  ex- 
change would  not  rise  much  above  the  gold  export 
point.  But  if  this  ratio  encouraged  the  continued  coin- 
age of  silver,  the  gold  would  eventually  be  entirely 
driven  out  of  the  currency  of  the  silver  coining  country. 
Then  the  rate  of  exchange  would  rise  even  higher,  for 
prices  in  the  silver  country  would  continue  to  rise  until 
silver  coin  had  no  greater  value  than  silver  bullion.  But 
ouce  the  gold  had  been  entirely  driven  out,  there  could 
be  no  further  effect  on  the  amount  of  money  and  there- 
fore on  prices,  in  other  countries,^  produced  by  the  coin- 
age of  silver.  Consequently,  the  prices  of  the  silver 
country  would  be  permanently  higher  than  formerly, 
compared  to  prices  abroad,  and  its  money  standard  of 
less  value.  Instead  of  the  rate  of  exchange  on  England, 
supposing  the  United  States  to  be  the  silver  standard 
country,  averaging  $486.65  =  £100,  it  might  average 
$973.30  =  £100,  or  some  other  new  and  higher  rate. 
The  rate  of  exchange  would  have  risen  tremendously. 
In  fact,  such  a  rise  in  the  rate  of  exchange  is  good  evi- 
dence of  a  cheaper  or  depreciated  currency.  But  the 
rate  of  exchange,  though  in  figures  much  higher  than 
before,  would  not  necessarily  be  above  par.  Instead, 
there  would  be  a  new  par.  $973.30  =  £100  might  have 
become  this  par.  Exchange  would  thereafter  fluctuate 
about  this  new  instead  of  about  the  old  and  lower  par. 

Par  of  exchange  would  no  longer  be  steady.  For  with 
one  country  on  a  silver  standard  and  the  other  on  a  gold 
standard,  the  monetary  unit  of  one,  e.g.  the  dollar,  would 
have  no  fixed  relation  to  the  monetary  unit  of  the  other, 

^See,  however,  remainder  of  this  section  (6). 


I40  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

e.g.  the  pound.  The  value  ratio  of  these  units  would 
vary  with  the  value  ratio  in  the  bulHon  markets,  of  sil- 
ver and  gold.  But  exchange  in  neither  country,  on  the 
other,  could  go  above  par  by  much  more  than  the  cost 
of  shipping  specie.  Exchange  in  the  silver  standard 
country  on  the  gold  standard  country,  would  be  Hmited 
by  the  cost  of  gold  in  terms  of  silver,  plus  the  cost  of 
shipment.^  Vice  versa,  exchange  in  the  gold  country  on 
the  silver  country,  could  not  go  higher  than  the  cost  of 
silver  in  terms  of  gold,  plus  the  cost  of  shipment. 

How  would  trade  balance  when  there  was  no  longer, 
between  two  such  trading  countries,  the  influence  of  price 
relations  in  the  same  precious  metal,  to  make  the  flow 
of  goods  one  way  balance  a  return  flow  ?  The  balance 
might  then  be  brought  about  by  the  flow  of  gold  one  way, 
and  of  silver  the  other.  If  we  should  for  a  time  buy  more 
in  England  than  the  Enghsh  of  us,  and  had  a  net  indebted- 
ness to  meet,  we  might  purchase  gold  in  the  bullion 
market  here,  with  which  to  settle.  This  (assuming  the 
United  States  to  be  on  a  silver  standard)  would  not 
directly  affect  our  prices,  but  would  increase  the  quantity 
of  money  and  tend  to  raise  prices  in  England.  In  this 
country  it  would  tend  to  make  gold  bulHon  scarce  and  dear 
as  compared  with  our  silver  money  and  with  other  goods. 
A  given  amount  of  English  money  would  buy  more 
American  dollars  than  before,  and  would  buy  more 
American  goods  than  before,  as  compared  with  the  goods 
it  would  buy  in  England.  That  is,  par  of  exchange  in 
England  on  the  United  States  would  be  lower.  There 
would  also,  of  course,  be  some  tendency  for  prices  in  one 
country  to  fall  and  in  the  other  to  rise  because  of  the  flow 

*  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  76-81 ;  cf .  Clare,  The 
A. B.C.  of  the  Foreign  Exchanges,  London  (Macmillan),  1893,  pp.  139-142.  » 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    141 

of  goods  as  well  as  because  of  the  flow  of  money.  The 
greater  supply  of  goods  in  the  importing  country,  the 
United  States,  in  relation  to  money,  would  tend  to  lower 
the  price  level;  while  the  outflow  of  goods  from  the 
exporting  country,  England,  would  tend,  there,  to  raise 
the  price  level. 

The  fact  that  a  given  amount  of  English  money  would 
buy  more  American  goods  than  before,  would  encourage 
EngHsh  buying  here ;  while  the  less  purchasing  power 
over  English  goods,  of  American  money,  would  dis- 
courage American  buying  in  England.^  Hence  trade 
would  reach  equihbrium  or  would  flow,  for  a  time,  in  the 
opposite  direction.^  Exchange  in  England  on  the  United 
States  would  rise  above  par,  and  specie  would  be  shipped. 

If  exchange  on  England  should  be  below  par  and  the 
flow  of  specie  should  be  from  them  to  us,  the  same  prin- 
ciple would  apply.  The  silver  sent  to  us  in  settlement 
of  balances  would  tend  to  raise  our  prices  and  lower 
the  value  of  silver  in  the  United  States.  Its  exportation 
from  England  would  tend  to  make  silver  in  England 
relatively  scarce  and  dear.  As  a  consequence,  a  given 
number  of  American  dollars  would  buy  more  pounds  than 
before  and  would  buy  more  goods  in  England  than 

*  Cf.  Bastable,  The  Theory  of  International  Trade,  fourth  edition,  London 
(Macmillan),  1903,  pp.  59,  60.  See  also  Professor  Marshall's  "memorandum" 
on  the  effect  in  international  trade  of  different  currencies,  Appendix  to  Final 
Report  of  the  Gold  and  Silver  Commission,  1888,  pp.  47-53. 

2  If  we  suppose  American  silver  exported  to  buy  English  gold  for  settling 
the  balance  against  us,  because  of  a  more  favorable  price  of  gold  in  England  com- 
pared to  silver,  we  shall  nevertheless  reach  the  same  final  conclusion.  On  this 
supposition,  the  outflow  of  silver  would  tend  to  lower  American  prices,  raising 
here  the  value  of  silver.  In  England,  silver  would  become  of  less  value  in  com- 
parison with  gold.  A  given  sum  of  EngUsh  money  would  buy  more  American 
money,  and  would  buy  more  American  goods  than  before  as  compared  with  the 
goods  it  would  buy  in  England.  Therefore,  the  flow  of  trade  must  reach  equilib- 
rium or  even  be  temporarily  reversed. 


142  TJfB  tXCHAl^OE'  MECHANISM  OF  COMMERCE 

before  as  compared  to  what  they  would  buy  here.  The 
surplus  flow  of  goods  from  the  United  States  to  England 
would,  other  things  equal,  be  brought  to  an  end.  If, 
therefore,  two  trading  countries  have,  respectively,  a 
silver  and  a  gold  standard,  the  laws  of  trade  between  them 
are  not  greatly  different  than  if  both  have  the  same 
standard.  It  is  still  true  that  each  will  buy  goods  of  the 
other ;  and  it  is  still  true  that  an  excess  flow  of  trade  in 
/one  direction  tends  so  to  change  monetary  and  price 
'  conditions  as  to  bring  its  own  termination. 

§7 

Exchange  between  Two  Countries  when  One  has  a  Gold 
and  the  Other  an  Inconvertible  Paper  Standard 

Let  us  now  suppose  the  case  of  a  paper  standard,  i.e. 
paper  money  not  redeemable  in  specie,  in  one  of  two 
trading  countries,  and  a  gold  standard  in  the  other,  as 
with  the  United  States  and  England  during  our  Civil 
War  period.  The  rate  of  exchange  in  the  paper  money 
country  on  the  other,  would  depend  chiefly  on  the  cost 
of  gold  in  terms  of  paper,  and  therefore  would  rise  as  the 
paper  money  depreciated  in  relation  to  gold.^  Thus, 
during  the  Civil  War,  exchange  in  the  United  States  on 
other  countries,  e.g.  England,  rose  to  a  very  high  figure, 
because  of  the  depreciation  of  the  greenbacks.  Con- 
versely, the  rate  of  exchange  in  the  gold  standard  country 
on  the  country  with  a  paper  standard  would  depend 
mainly  on  the  cost  of  this  paper  money  in  terms  of  gold, 
and  therefore  would  fall  as  the  paper  money  depreciated.^ 
In  the  paper  money  country,  the  upper  limit  of  exchange 
on  the  other  cannot  much  exceed  the  cost  of  purchasing 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  69,  70.  *  /j j^^ 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    143 

gold  with  paper,  plus  the  cost  of  shipping  the  gold.^ 
If  we  regard  exchange  between  two  such  countries  as  at 
par  (though  the  paper  money  might  be  depreciated  far 
below  par)  when  the  money  of  the  paper  standard  coun- 
try will  buy  just  as  much  exchange  on  the  gold  standard 
country  as  it  will  buy  gold  at  home,^  then  we  may  say 
that  exchange  could  rise  above  par  by  the  cost  of  shipping 
specie.^  In  general,  we  may  say  that  exchange  might 
either  rise  above  or  fall  below  this  par,  by  the  cost  of 
specie  shipment,  just  as  it  might  rise  above  or  fall  below 
par  by  the  cost  of  specie  shipment  if  both  countries  had 
the  same  specie  as  standard. 
When  one  of  two  countries  has  inconvertible  paper  and 

UbU. 

'This  is  the  logical  though  not  the  ordinary  use  of  the  word  "par"  in  re- 
lation to  exchange,  when  one  country  has  a  depreciated  currency.  It  is  custom- 
ary to  regard  as  par  what  would  be  par  if  there  were  no  depreciation.  Strictly 
speaking,  however,  the  departure  from  this  rate,  due  to  depredation,  means  a 
departure  of  the  money  from  par,  rather  than  of  exchange. 

'  This  is  not  inconsistent  with  Bastable's  statement  {Theory  of  International 
Trade,  pp.  87,  88)  regarding  the  possible  rise  of  the  exchanges  on  other  countries, 
in  a  country  having  an  inconvertible  but  not  depreciated  paper  money.  In 
such  a  case,  it  is  said,  if  a  sudden  demand  for  exchange  and,  consequently,  for 
gold  to  export,  is  coincident,  in  the  paper  money  country,  with  a  temporarily 
inadequate  supply  of  gold,  exchange  may  rise  above  the  usual  specie  shipping 
point.  But  though  the  rate  may  go  up  beyond  the  usual  shipping  point,  it  can 
hardly  be  said  to  do  so  if  the  paper  money  is  in  no  sense  depreciated.  Though 
the  paper  money  may  not  have  depreciated  in  relation  to  goods  in  general, 
and  may  not  have  depreciated,  permanently,  in  relation  to  gold,  yet,  for  the  time 
being,  it  has  depreciated  compared  to  gold  in  the  paper  standard  country.  Under 
such  circumstances,  however,  it  may  fairly  be  emphasized  that  the  rise  of  ex- 
change is  due  rather  to  a  local  rise  in  the  value  of  gold  than  to  a  fall  in  that  of 
the  paper. 

A  special  case  discussed  by  Goschen  (The  Theory  of  the  Foreign  Exchanges, 
pp.  70-72),  is  that  of  a  country  which,  having  an  inconvertible  paper  money, 
has  also  forbidden  the  export  of  the  precious  metals.  In  such  a  country,  exchange 
on  others  cannot  be  prevented,  by  shipment  of  specie,  from  rising  above  the 
gold  shipping  point,  since  the  law  forbids  such  shipment.  Except  as  the  law 
may  be  evaded,  a  rising  exchange  rate  can  then  only  be  limited  by  a  retardation 
of  imports  and  a  stimulation  of  exports  (see  §  9  of  this  chapter)  or,  for  a  time,  by 
borrowing  from  abroad  (see  Goschen,  Foreign  Exchanges,  loc.  cit.). 


144  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

the  other  a  gold  standard,  the  effect  on  prices,  produced 
by  the  flow  of  specie  consequent  on  trade  between  them, 
could  occur  only  in  the  gold  standard  country.  When 
the  paper  standard  country  has  a  balance  to  pay,  gotd 
may  be  purchased  with  this  paper  money  and  exported 
(or,  which  for  purposes  of  our  discussion  amounts  to  the 
same  thing,  imported  by  the  gold  standard  country). 
This  will  raise  prices  in  the  gold  standard  country  to 
which  the  gold  flows.  If  the  trade,  however,  is  between 
a  paper  standard  country  and  several  gold  standard 
countries,  the  effect  on  the  latter  will  be  more  diffused 
and  their  prices  raised  but  sUghtly.  But  the  outflow 
of  gold  bullion  from  the  paper  standard  country  will 
tend,  if  long  continued,  to  make  gold  in  that  country 
scarce  and  dear  in  relation  to  other  desired  goods.  A 
given  amount  of  gold  will  buy  not  only  more  paper 
money,  but  also  more  of  other  goods  than  before.  Drafts 
drawn  on  the  gold  standard  country,  or  remitted  by  its 
people,  in  payment  for  goods  purchased  in  the  paper 
standard  country,  will  represent  less  gold  than  previously 
for  the  same  goods  bought.  Therefore,  more  goods 
will  be  purchased  in  the  paper  standard  country  by  the 
people  of  the  other,  and  gold  will  flow  back  again  to 
the  former  country.  This  tendency  is  accentuated  by  the 
flow  of  goods.  If,  at  first,  goods  are  imported  by  the 
paper  standard  country,  the  larger  supply  of  goods  in  that 
country,  relative  to  the  paper  money  and  to  gold,  tends 
to  make  the  prices  of  these  goods  lower  in  either  standard. 
In  the  exporting  country,  relative  scarcity  of  goods  tends 
to  make  prices  somewhat  higher  measured  in  gold. 
Hence,  for  this  reason  also,  more  goods  are  bought  with 
gold  in  the  paper  standard  country,  and  gold  tends  to 
flow  to  that  country. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    t^ 

§8 

Exchange  between  Two   Countries  when  Both  have  In- 
convertible Paper  Standards 

Suppose,  next,  that  there  is  in  each  of  two  trading 
countries  an  inconvertible  paper  standard.  Then  the 
rate  of  exchange  in  either  upon  the  other,  so  long  as  gold 
is  the  medium  for  settHng  international  balances,  will 
depend  on  the  value  of  both  currencies  in  relation  to  gold. 
Suppose  the  two  countries  to  be  the  United  States  and 
France.  Then,  in  the  United  States,  exchange  on  France 
would  rise  if  American  money  depreciated  compared 
to  gold  (French  money  remaining  the  same) ,  or  if  French 
money  appreciated  in  relation  to  gold  (American  money 
remaining  the  same),  or  if,  simultaneously,  American 
money  depreciated  and  French  money  appreciated.  The 
same  causes  would  make  exchange  in  France  on  the 
United  States  fall.  The  rise  in  exchange  on  France 
and  the  fall  in  exchange  on  the  United  States  would  be 
limited  by  the  depreciation  of  the  American  money 
plus  the  appreciation  of  the  French  money,  plus  the  cost 
of  specie  shipment.  For  if  American  money  depreciated 
one-half  compared  to  gold,  exchange  on  France  (excluding 
the  cost  of  gold  shipment)  would  double,  since  it  would 
take  twice  as  many  American  dollars  to  buy  the  same 
amount  of  gold  for  shipment  to  France,  and,  therefore, 
to  buy  the  gold  equivalent  of  a  certain  number  of  francs. 
Likewise,  if  French  money  doubled  in  value  in  relation 
to  gold,  exchange  on  France  would  double,  since  it  would 
take  twice  as  many  dollars  as  before  to  buy  the  double 
amount  of  gold  which  was  now  the  equivalent  of  a  given 
number  of  the  doubled  value  francs.  Above  this 
amount,  exchange  could  rise  by  the  cost  of  shipping  gold. 


146  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

Under  the  assumed  circumstances,  the  currencies  of 
the  two  countries  would  be  unrelated  to  each  other.     No 
amount  of  buying  by  the  merchants  of  the  United  States, 
in  France  could,  through  a  flow  of  money,  lower  Ameri- 
can or  raise  French  prices,  for  American  money  would 
not  be  legal  tender  in  France  or  (being  paper)  of  any 
intrinsic  value  there.     Neither  could  French  buying  in 
the  United  States  produce,  by  the  flow  of  money,  the 
reverse  consequence.     How,  then,  would  excess  buying 
by  one  country   in   the  other  eventually  cause  more 
buying  by  the  second  in  the  first  ?    It  would  have  this 
effect  through  the  flow  of  gold  and  the  consequent  influ- 
ence on  the  value  of  gold  in  the  two  countries ;  and  also 
through  the  flow  of  goods  and  the  effect  of  that  flow  on 
prices  in  the  two  countries  and  so  on  the  relative  values 
A  of  gold,  in  both  countries,  in  relation  to  goods. 
'I      If  the  United  States  should  buy  more  of  France  in  any 
/  period  than  it  sold  to  France,  gold  would  flow  to  France. 
/  Gold  would  therefore  come  to  have  more  value  in  the 
/   United  States,  where  it  was  scarce,  and  less  value  in 
/    France,  than  before.    A  given  number  of  francs  would  buy 
/    more  gold,  and  a  given  amount  of  gold  would  buy  more 
dollars.     Par  of  exchange,  in  the  sense  here  used,  would 
be  lower  in  France  on  the  United  States,  and  higher  in 
the  United  States  on  France.    This  means  that  in  terms 
of  French  money,  goods  could  be  purchased  in  the  United 
States  more  cheaply  than  before;    while  in  terms  of 
American  money,  French  goods  would  be  more  expensive 
than  before.    As  a  consequence,  the  French  would  buy 
more  American  goods,  and  Americans  would  buy  less 
French  goods;    the  rate  of  exchange  in  France  on  the 
United  States  would  rise  above  this  low  par,  and  in  the 
United  States  on  France  it  would  fall ;  and  gold  would 
flow  back  from  France  to  the  United  States. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    147 

In  addition,  if  the  United  States  should  buy  a  net 
balance  of  goods  from  France,  in  any  period,  this  would 
tend  to  make  goods  more  plentiful  in  the  United  States 
and  less  so  in  France,  in  relation  to  gold,  so  that,  for  this 
reason  also,  it  would  become  more  profitable  than  before 
to  send  gold  from  France  to  the  United  States  for  goods. 

§9 

Exchange   between    Two   Countries,   Assuming  Effective 
Prohibition  of  Specie  Shipment 

So  far  we  have  assumed,  even  when  discussing  trade 
between  countries  having  unrelated  currencies,  that  gold 
or  silver  would  be  used  to  settle  international  balances. 
But  suppose  that  the  mediaeval  theory  of  prohibiting 
the  export  of  specie  were  still  in  vogue  and  were  com- 
monly appHed.  Would  there  be,  then,  any  limits  to  the 
fluctuations  of  exchange  (assuming  obligations  still  to 
be  settled  by  using  drafts),  and  would  there  still  be  a 
tendency  for  the  trade  in  opposite  directions,  to  balance  ? 
Under  usual  existing  conditions,  the  fluctuations  of  ex- 
change with  any  country  are  limited,  as  we  have  seen, 
by  the  cost  of  shipping  specie.  Any  further  rise  or  fall 
is  checked  by  specie  shipment  and  by  the  consequent 
efltect  on  supply  of  drafts,  or  demand  for  them,  or  both. 
But  if  specie  shipment  were  prohibited,  and  prohibited 
at  all  effectively,  the  Hmits  to  exchange  fluctuations  could 
not  be  so  narrow.  The  rate  of  exchange,  for  example, 
in  the  United  States  on  England,  if  the  balance  of  obKga- 
tions  were  markedly  in  England's  favor,  could  then  go 
considerably  above  $488.65  without  at  once  increasing 
the  supply  of  or  decreasing  the  demand  for  drafts  on 
England,  to  such  an  extent  as  to  stop  the  rise.    Since 


148  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

gold  could  not  be  exported,  Americans  owing  money  in 
England  would  have  to  settle  by  remitting  drafts  or  by 
redeeming  drafts  drawn  against  them.^  In  the  latter 
case,  American  banks  must  purchase  drafts  on  England 
in  order  to  settle  with  correspondents,  since  the  alterna- 
tive of  shipping  specie  is  excluded.  Drafts  on  England 
might,  therefore,  sell  at  a  rate  which  American  debtors 
and  debtor  banks  would  refuse  to  pay  if  they  had  the 
forbidden  alternative. 

Yet  there  would  still  be  limits,  though  wider  and 
perhaps  less  definite  ones,  to  the  fluctuations  in  the  price 
of  drafts.  The  high  price  of  drafts  on  England  would 
encourage  and  stimulate  the  sale  of  American  goods  in 
England  and  would  discourage  buying  goods  from  Eng- 
land. Goods  which  would  bring,  in  England,  say  £ioo, 
but  which  would  not  ordinarily  be  sent  there  for  sale, 
because  that  sum  yielded  no  profit,  might  be  exported  if 
a  draft  on  England  for  £ioo  would  sell,  here,  for  $495. 
And  the  sale  of  goods  in  England,  thus  stimulated,  would 
tend,  by  increasing  the  supply  of  drafts  on  England,  to 
prevent  further  rise  in  the  prices  of  such  drafts.  Also, 
goods  which  could  be  purchased  in  England  for  £100 
and  which,  if  $486.65  would  buy  a  draft  for  £100  and 
so  would  pay  for  the  goods,  would  be  bought  in  England, 
very  probably  would  not  be  bought  if  the  draft  necessary 
to  pay  for  them  cost  $495.  • 

Conversely,  even  though  exchange  on  England  fell 
below  the  gold  shipping  point,  because  of  a  net  balance 
owing  from  England  to  us,  combined  with  an  English 
prohibition  on  the  outflow  of  gold  from  England,  such  a 
fall  in  exchange  would  not  be  without  limit.     For  it 

*  Renewal  of  credit,  use  of  finance  bills,  etc.,  would  of  course  serve  as  tempo- 
rary expedients  to  postpone  settlement. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE     149 

would  encourage  buying  in  and  discourage  selling  to 
England.  Goods  which  could  be  sold  in  England  for 
£100  and  which  it  would  ordinarily  pay  to  ship  there, 
it  might  not  be  profitable  to  ship  if  a  draft  on  London 
for  £100  would  only  reaHze,  in  New  York,  $460  or  less. 
The  consequent  refusal  to  ship  goods  to  England  would 
tend  to  decrease  the  supply  of  drafts  on  England  and  to 
prevent  further  fall  in  their  prices.  At  the  same  time, 
it  might  become  more  profitable  for  us  to  buy  goods  in 
England,  paying  for  these  goods  by  purchasing  and 
maiHng  the  low-priced  London  drafts  and  so  adding  to 
the  demand  for  such  drafts. 

During  the  summer  and  fall  of  this  year  (191 5)  drafts 
on  the  principal  European  belligerent  countries  have 
been  selling  at  rates  far  below  the  ordinary,  gold-ship- 
ping points.  Sight  drafts  on  London,  for  instance, 
have  sold  at  4.70,  at  4.60,  even  at  4.50,  and  correspond- 
ing discounts  have  ruled  with  respect  to  other  European 
centers.  It  would  seem  that  these  discounts  cannot 
be  sufficiently  explained  by  citing  the  war  risk  of  gold 
shipment,  since  war  risk  insurance  is  but  i  per  cent  in 
British  bottoms  and  in  American  vessels  is  even  less. 
This  risk,  in  addition  to  the  ordinary  cost  and  risk  of 
shipment,  might  account  for  a  rate  on  London  as  low 
as  4.80  or  4.79,  but  hardly  for  a  rate  much  lower.  There 
seems  no  escape  from  the  conclusion  that  interference 
with  gold  exports  from  the  countries  at  war  is  an  im- 
portant factor  in  the  problem.  Such  interference  there 
has  been  and  is.^    For  example,  France  has  forbidden 

*The  more  important  commercial  countries  engaged  in  the  present  war, 
e.g.  Great  Britain,  France,  and  Germany,  would  appear  thus  far  (October,  191 5) 
to  have  been  successful  in  preventing  depreciation  of  their  paper  money,  in  the 
commonly  understood  sense  of  depreciation  in  relation  to  gold.  The  success 
which  they  have  had  in  this  direction  is  probably  due,  in  considerable  measure. 


I50  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

any  person  other  than  the  Bank  of  France  to  export 
gold,  and  the  Bank  of  France  is  controlled  by  the  govern- 
ment, which  appoints  its  manager.  Great  Britain  has 
not  formally  prohibited  the  export  of  gold ;  but  probably 
no  English  bank  would  venture,  under  existing  circum- 
stances, to  export  gold  without  the  approval  of  the 
Bank  of  England,  and  the  Bank  of  England  will  arrange 
for  the  export  of  so  much  gold  only  as  its  officials  and 
the  government  think  may  wisely  be  parted  with. 
Hence  the  ordinary  free  flow  of  gold  has  ceased,  price 
levels  in  America  and  in  Europe  are  not  closely  related 
through  such  a  flow,  and  exchange  rates  can  fall,  and 
have  fallen,  far  below  par.  To  such  an  extent  has  this 
occurred  that  we  should  perhaps  soon  cease  to  find  it 
profitable  to  sell  food  supplies,  munitions,  etc.,  to  the 
Entente  Allies,  had  they  not  arranged  to  correct  mat- 
ters, in  part,  by  borrowing  of  us  heavily  through  the 
sale  of  their  bonds  in  the  United  States. 

When  balances  are  habitually  settled  by  the  shipment 
of  gold  (or  other  precious  metals),  as  in  modern  trade, 
the  limits  of  fluctuation  in  exchange  are  narrow  because 
gold,  having  large  value  in  small  bulk,  can  be  shipped 
for  a  small  per  cent  of  its  value.  An  excess  of  trade 
in  one  direction,  therefore,  acts  largely  through  a  flow 
of  gold  as  an  intermediate  cause,  in  bringing  about  a 
balancing  flow  of  trade  in  the  contrary  direction.  This 
flow  of  gold  affects  prices  in  both  countries,  if  both  have 
the  gold  standard.     In  any  case,  it  affects  the  relative 

to  the  fact  that  they  will  not  allow  gold  to  be  exported.  They  have  thus  nar- 
rowed the  market  for  gold  and  have,  in  effect,  cheapened  it  along  with  the 
paper.  Hence,  the  paper  money  may  not  appear  to  be  depreciated  even  though, 
in  the  sense  of  its  piu-chasing  power  over  goods,  it  is  so.  It  is  not  denied,  of 
course,  that,  under  all  the  circumstances,  a  belligerent  government  may  find  it 
desirable  to  husband  its  stock  of  gold  and  avoid,  if  possible,  any  depredation 
of  the  sort  usually  meant  by  the  term. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE     151 

purchasing  power  of  gold  in  these  countries,  and  the 
amount  of  goods  that  the  currency  of  the  one,  by  being 
first  exchanged  for  gold,  will  buy  in  the  other,  compared 
to  what  it  will  buy  at  home.  There  follows,  as  a  result 
of  this  change  in  relative  prices  or  in  relative  values  of 
the  two  money  standards,  a  change  in  the  flow  of  trade. 
This  change  in  the  flow  of  trade  is,  therefore,  in  large 
part,  but  an  indirect  consequence,  through  the  flow  of 
gold,  of  a  rising  or  falling  rate  of  exchange.  But  if  jfehe" 
flow  of  specie  is  effectively  prohibited,  and  the  fluctuations 
in  exchange  are,  in  consequence,  greater  (assuming  drafts 
to  be  still  used  as  the  chief  means  of  settling  obligations 
between  countries),  the  high  and  low  prices  of  drafts  will 
act  with  greater  force  directly  on  the  flow  of  trade. 

It  should  be  emphasized  that  high  and  low  exchange 
have  always,  to  some  extent,  this  direct  influence.  If  a 
draft  on  England  for  £100  will  sell  for  $488  in  New  York, 
it  may  be  profitable  to  export  goods  to  England  which  it 
would  not  pay  to  export  if  exchange  were  low.  Simi- 
larly, if  drafts  on  England  for  £100  can  be  secured  for 
$484.70,  it  may  be  worth  while  to  buy  goods  there  which, 
if  exchange  were  higher,  would  not  be  purchased.  A  flow 
of  trade  in  one  direction  has  always,  then,  some  slight 
tendency  to  bring  about  its  own  termination  through 
affecting  the  rate  of  exchange,  and  thereby  the  direction 
of  trade.^  But  this  more  direct  influence  is  greater, 
because  the  possible  fluctuations  in  exchange  are  greater, 
if  and  when  specie  cannot  be  exported  from  either  of 
two  trading  countries.  Our  conclusion  is  that  whatever 
the  relation  of  the  currencies  of  two  trading  countries, 
and  whatever  the  mechanism  of  settUng  balances,  or 
whatever  the  restrictions  on  settlement  by  the  use  of  any 

1  Cf.  Ch.  V.  (of  Part  I),  §  6, 


152   THE  EXCHANGE  MECHANISM  OF  COMMERCE 

special  commodity,  e.g.  gold,  an  excess  flow  of  trade  in 
one  direction  introduces  always  a  tendency  towards  an 
opposite  and  balancing  flow. 

§  lo 

The  Effect  on  the  Rate  of  Exchange  of  High  Import  and 
Export  Duties 

Let  us  now  give  very  brief  consideration  to  the  effects 
on  exchange  of  high  import  duties,  e.g.  the  so-called 
protective  tariff.  The  protective  tariff  is  a  high  tax  on 
imports,  intentionally  made  so  high  as  to  prevent  or 
decrease  imports,  and  encourage  buying  at  home. 
For  the  time  being,  the  country  adopting  such  a  policy 
will  export  an  excess,  the  rate  of  exchange  on  other  coun- 
tries will  be  low,  and  specie  will  flow  in.  Then  prices 
rise  in  the  protectionist  country  in  relation  to  prices 
elsewhere,  exports  are  checked,  and  an  equilibrium  is 
reached ;  and,  in  the  absence  of  other  disturbing  causes, 
exchange  will  again  average  par. 

On  the  other  hand,  the  first  effect  of  a  high  tariff  on 
exports  would  be  to  decrease  exports.  For  a  while 
imports  would  be  in  excess.  Therefore,  the  rate  of 
exchange  would  rise.  Eventually  specie  would  flow 
out,  prices  would  fall,  impoiits  and  exports  would 
again  balance  (other  disturbing  factors  absent),  and 
there  would  no  longer  be  the  tendency  caused  by  excess 
imports  for  the  fall  of  prices  to  continue. 

•     §  II 

Summary 

In  this  chapter  the  attempt  has  been  made  to  bring 
together    various    considerations    regarding    exchange. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE     153 

which  seemed  to  have  no  proper  place  in  the  chapters 
preceding.  To  begin  with,  a  distinction  was  made 
between  sight  drafts  and  those  payable  some  time  after 
sight.  A  study  of  the  pure  rate  of  exchange  has  to  do 
only  with  the  former.  The  prices  of  the  latter  depend 
also  upon  the  rate  of  interest.  Two  possible  methods 
of  procedure  when  an  American  bank  invests,  for  the 
interest,  in  drafts  on  foreigners,  were  described.  It  was 
shown  that  the  prices  of  long  drafts  may  be  influenced- 
by  the  rate  of  interest  in  the  drawing  and  in  the  accept- 
ing country.  If  the  rate  of  interest  in  the  accepting 
country  is  the  lower,  this  rate  determines  the  prices  of  V 
long  drafts;  but  if  the  rate  of  interest  in  the  drawing 
country  is  the  lower,  purchase  of  the  drafts  by  investors 
or  investing  banks  in  that  country  may  make  these  drafts 
sell  for  somewhat  more  than  the  higher  rate  of  interest 
in  the  accepting  country  would  otherwise  allow. 

Consideration  was  given  to  the  influence,  on  the  pure 
rate  of  exchange  and  on  the  flow  of  specie,  of  changes  in 
interest  or  discount  rates  in  different  countries.  It  was 
seen  that  a  rise  of  the  bank  discount  rate  in  any  country 
tends  to  create,  elsewhere,  high  rates  of  exchange  on  that 
country  and  a  flow  of  specie  to  it.  But  it  was  also  seen 
that  the  chief  effect  of  such  a  rise  in  bank  discount  is  to 
check  undue  credit  expansion  or  reduce  excessive  credit. 
Only  as  it  has  this  effect,  will  the  inflow  of  specie  be  pre- 
vented from  so  raising  prices  as  to  result  in  a  subsequent 
corresponding  outflow.  Since  interest  rates  and  prices 
in  different  countries  are  related,  it  follows  that  a  finan- 
cial panic  in  one  country  must  produce  some,  though  per- 
haps comparatively  mild,  effects  upon  other  countries. 

The  rates  of  exchange  between  countries  having  dif- 
ferent monetary  standards  were  next  considered.     If 


154  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

one  country  has  gold  and  another  silver,  exchange  can 
fluctuate  as  the  ratio  of  value  of  silver  to  gold  fluctuates, 
and,  in  addition,  by  the  cost  of  specie  shipment.  If  one 
country  has  gold  and  the  other  has  inconvertible  paper, 
exchange  in  the  latter  on  the  former  can  rise  (and  in  the 
former  on  the  latter,  fall)  by  the  amount  of  depreciation 
of  the  paper  in  terms  of  gold,  plus  the  cost  of  gold  ship- 
ment. If  both  countries  have  inconvertible  paper,  ex- 
change in  either  on  the  other  can  rise  by  the  amount  of 
depreciation  in  the  currency  of  the  first  plus  the  amount 
of  appreciation  in  that  of  the  second,  plus  the  cost  of 
specie  shipment.  Whatever  the  monetary  standard  or 
standards  of  trading  countries,  exchange  can  fluctuate 
beyond  the  above  assigned  Hmits,  if  the  movement  of 
specie  is  effectively  prohibited.  But  whatever  the 
standard  or  standards,  it  appeared  that  trade  cannot 
flow  continuously  in  one  direction  without  introducing 
a  tendency  to  a  reverse  flow.  By  acting  on  relative 
price  levels,  or  on  relative  values  of  currency  in  relation 
to  gold,  or  only  on  rates  of  exchange,  the  surplus  flow  in 
one  direction  will  eventually  bring  itself  to  an  end. 

Lastly,  brief  attention  was  given  to  the  effects  on 
exchange,  of  import  and  export  duties.  The  former  make 
exchange  on  other  countries  temporarily  lower.  The 
latter  make  it  temporarily  higher.  In  the  former  case, 
equilibrium  is  reached,  after  an  inflow  of  specie,  with  a 
higher  level  of  prices  m  the  country  levying  the  duties. 
In  the  latter  case,  when,  after  an  outflow  of  specie,  equi- 
librium is  again  reached,  the  level  of  prices  in  the  duty- 
levying  country  is  lower. 


INDEX 


Acceptance  bills,  form  of  documentary 

commercial  drafts  called,  69. 
Arbitraging  in  exchange,  96-97. 


B 


Bank  acceptances,  system  of,  used  in 
Europe,  37-39,  69. 

Bank  credit,  nature  of,  26  ff . ;  relation 
of  money,  together  with,  to  prices, 
43-45  ;  fluctuations  of,  due  to  periods 
of  hope  and  confidence  and  doubt 
and  fear,  46;  changes  in,  resulting 
from  panics,  46-47  ;  means  provided 
for  avoiding  violent  fluctuations  of, 

47-49- 

Bank  deposits,  28. 

Bank  drafts,  use  of,  52;  both  drawers 
and  drawees  of,  are  banks,  54; 
settlement  of  obligations  by,  when 
debtors  remit  to  creditors,  61  ff. ; 
different  types  of,  67-70.  See  Long 
drafts  and  Sight  drafts. 

Banking,  commercial,  28-30;  analysis 
of  the  relations  to  each  other  of 
persons  concerned  in,  30-33 ;  ad- 
vantages possessed  by,  for  business 
men,  both  as  lenders  and  borrowers, 
33-40- 

Bank  notes,  are  credit  obligations  of 
banks  to  holders  of,  41 ;  protection 
of  holders  against  loss,  41-43 ;  pro- 
visions of  Federal  Reserve  Act 
relative  to,  42-43. 

Bank  of  England,  emergency  reserve 
of,  47. 

Bank  reserves,  42,  44;  method  of 
maintaining  proper  relation  be 
tween  deposits  and,  44—45. 

Banks,   function  of,   to  act   as  inter 


mediaries  between  borrowers  and 
lenders,  30-33 ;  Federal  reserve, 
42-43. 

Barter,  primitive  trade  called,  i. 

Bastable,  The  fheory  of  International 
Trade,    cited,    92,    113,    141,    143. 

Bills  of  exchange,  26,  27,  51-53;  ad- 
vantage of,  over  checks  for  long- 
distance transactions,  52-53;  nature 
of,  53—54 ;  relations  of  bank  to  other 
parties  concerned  in,  53-54;  il- 
lustration of  use  of,  to  settle  obliga- 
tions, assuming  no  banks,  54-56; 
settlement  of  obligations  by,  through 
intermediation  of  banks,  assuming 
creditors  to  draw  drafts  on  debtors, 
56-61 ;  settlement  by  bank  drafts, 
when  debtors  remit  to  creditors,  61- 
65  ;  variety  of  types  of,  67-70 ;  sight 
drafts  and  long  bills,  67;  "clean" 
bills  and  documentary,  67-69 ;  dis- 
count of,  69-70;  sale  of  demand 
drafts  against  remittances  of  long 
bills,  71-73;  method  of  drawing  of, 
by  letters  of  credit,  94-96 ;  specula- 
tion in,  96-100;  relation  between 
price  of  long  drafts  and  rate  of  in- 
terest or  discount,  126-127;  holding 
of  long  drafts  on  foreign  countries 
by  American  banks,  as  investments, 
127-130;  influence  on  price  of  long 
drafts  of  interest  rate  in  drawing 
country  and  interest  rate  in  country 
drawn  upon,  131-133  ;  effect  of  bank 
discount  rate  on  price  of  demand 
drafts  and  the  flow  of  specie,  133- 
136 ;  fluctuations  in  price  of,  in  case 
of  prohibition  of  specie  shipment, 
147-152. 

Bimetallism,  operation  of  theory  of, 
16-18. 

Borrowers,  relation  between  lenders 
and,  in  commercial  banking,  30-33; 


155 


156 


INDEX 


benefits  to,   from  banking  system, 
35-37- 


Canada,  protection  of  holders  of  bank 
notes,  under  banking  system  of, 
41. 

Checks  on  banks,  common  form  of 
credit,  26,  27 ;  similarity  of  bills  of 
exchange  to,  52;  advantages  of 
bills  of  exchange  over,  in  long-dis- 
tance transactions,  52-53. 

Clare,  The  A. B.C.  of  the  Foreign  Ex- 
changes,  cited  63,   83,   93,  97,    140. 

"Clean"  bills,  defined,  67. 

Clearing  houses,  29,  30. 

Commercial  drafts,  use  of,  52  flf. ; 
character  of  drawers  and  drawees 
of,  53-54;  method  of  using,  for 
settlement  of '  obligations,   54  ff. 

Competition,  effect  of,  on  prices,  6-8. 

Credit,  substitution  of,  for  money, 
26-27. 

Crops,  relation  between  rate  of  ex- 
change and,  82-83. 

Currencies,  effect  of  difference  in,  on 
exchange  between  two  countries, 
138-142. 

Currency,  use  of  term,  26. 

Currency  loans,  85,  86. 

Customer's  check,  use  of,  for  money, 
27. 


D 


Demand  drafts,  sale  of,  against  re- 
mittances of  long  bills,  71-73.  See 
Sight  drafts. 

Discount,  effect  of,  on  price  of  long 
drafts,  126-127;  effect  of  bank  dis- 
count rate  on  price  of  demand 
drafts  and  the  flow  of  specie,  133- 
136;  effect  of  panics  on  rate  of, 
137-138. 

Discounting  of  documentary  payment 
bills,  69-70. 

Discount  market,  absence  of  a,  in 
United  States,  72-73. 

Documentary  commercial  drafts,  67, 
68-69. 

Domestic  exchange,  cost  of  money 
shipment  in,  115-116. 


E 


Edgeworth,  "Report  on  Monetary 
Standard,"  cited,  3. 

England,  exchange  transactions  be- 
tween America  and,  62-65  J  dis- 
counting in,  of  bills  drawn  by  Ameri- 
cans on  their  English  debtors,  71- 
72. 

Equation  of  exchange  of  money,  3-4, 
24;  statement  of,  including  bank 
credit,  43. 

Escher,  Elements  of  Foreign  Exchange, 
cited,  6s,  67,  69,  70,  71,  85,  90,  93, 
94,  96,  97,  99,  109,  III. 

European  war,  and  the  exchange 
market,  107  ;  effect  of,  on  flow  of 
specie  abroad,  136  n. 

Exchange,  foreign  and  domestic,  52- 
53;  par  of,  77-78,  139;  place 
speculation  or  arbitraging  in,  96- 
97;  time  speculation  in,  97-100; 
between  two  countries  when  one 
has  a  gold  and  the  other  a  silver 
standard,  138-142.  See  Bills  of 
exchange    and    Rate    of    exchange. 

Exchangeability  of  money,  2. 

Exchange  banks  and  brokers  53,  56; 
how    profits    are    made    by,    65-67. 

Exchange  market,  the,  65 ;  effect  on, 
of  disturbed  political  or  industrial 
conditions,  83-84 ;  demoralization 
of,  by  the  European  war,  107. 

Exportation  of  specie  and  the  rate  of 
exchange,  107-111. 

Export  duties,  effect  of  high,  on  rate 
of  exchange,  151. 

Export  trade,  influence  of  rate  of  ex- 
change on,  118-H9. 


Federal  Reserve  Act,  provisions  of, 
relative  to  national  bank  notes, 
42-43 ;  function  of  Federal  reserve 
banks  established  by,  47 ;  pro- 
visions of,  for  suspending  reserve 
requirements,  48 ;  rediscounting  per- 
mitted and  encouraged  by,  73. 

Federal  reserve  banks,  reserves  kept 
by,  47- 

Fiat  money,  8,  13. 

Finance  bills,  90-93. 


INDEX 


157 


Financial    disturbances,    influence    of, 

on  rate  of  exchange,   113-114. 
Firsts    and    seconds,    explanation    of 

terms,  applied  to  drafts,  128. 
Fisher,   Irving,   Elementary  Principles 

of  Economics,    cited,    5,    17;     The 

Purchasing  Power  of  Money,  cited, 

14,  19,  22,  28,  43,  45,  137. 
Foreign  exchange,  nature  and  method 

of,  51  ff. 
Futures,    speculation    in,    in    foreign 

exchange,  98-99. 


Gold,  value  of  money  as  related  to 
value  of,  21-22.     See  Specie. 

Goschen,  The  Theory  of  the  Foreign 
Exchanges,  cited,  89,  92,  113,  131, 
134,  136,  140,  142,  143. 


Hadley,  Economics,  cited,  3,  7. 


Importation  of  specie  and  the  rate  of 
exchange,  111-113. 

Importations,  influence  of  rate  of  ex- 
change on  amount  of,  118-119. 

Import  duties,  effect  of  high,  on  rate 
of  exchange,  152.  See  Protective 
tariff. 

Individualism,  philosophy  of,  applied 
to  use  of  finance  bills,  92-93. 

Insurance  rates  on  gold  shipments,  107. 

Interest,  loss  of,  during  transportation 
of  gold,  107-109 ;  relation  between 
rate  of,  and  price  of  long  drafts, 
126-127,  131-133. 

Investments,  long  run  effect  of  inter- 
national, upon  rate  of  exchange  and 
flow  of  money,  120-122;  long 
drafts  on  foreign  countries  held  by 
American  banks  as,  127-130. 


Jacobs,    L.  M.,    "Bank  Acceptances" 

by,  cited,  37  n.,  73. 
Joint    account,    investment    by    two 

banks  for,  93-94- 


Kemmerer,  Money  and  Credit  Instru- 
ments in  their  Relation  to  General 
Prices,  cited,  43. 


Laws  of  money,  i  ff. 

Lenders,  viewed  as  persons  who  pro- 
vide waiting,  30-33 ;  advantages  to, 
of  system  of  commercial  banking, 
34-35- 

Letters  of  credit,  analysis  of  relations 
involved  in,  94-96. 

Limping  standard,  conditions  for  suc- 
cessful operation  of  the,   19-21. 

Loans,  short  time,  made  through  in- 
termediation of  exchange  market, 
85  ff. ;  sterling  and  currency,  85- 
86. 

London,  the  world's  financial  centre, 
63-64;  effect  on  disposal  of  long 
drafts  at  lower  discount  rate  in, 
than  in  New  York,  133. 

Long  drafts  or  bills,  67;  sale  of  de- 
mand drafts  by  banks,  against  re- 
mittances of,  71-73;  effect  on  price 
of,  of  rate  of  interest  or  discount, 
126-127  ;  me'thod  of  procedure  when 
held  as  investments  by  American 
banks,  127-130 ;  influence  on  price  of, 
of  interest  rate  in  drawing  country 
and  of  interest  rate  in  coimtry 
drawn  upon,  131-133. 


M 


Margraff,  International  Exchange,  cited, 
70,  96  n.,  128,  130. 

Marks,  Lawrence  M.,  statistics  of  rate 
of  exchange  compiled  by,  83  n. 

Marshall,  memorandum  on  effect  in 
international  trade  of  different 
currencies,  141  n. 

Mill,  J.  S.,  Principles  of  Political 
Economy,  cited,  5. 

Monetary  standards,  effect  of  different, 
on  exchange  between  two  countries 
138-142. 

Money,  laws  of,  i  ff. ;  position  of 
as  a  medium  of  exchange.  2-3 ;  re- 
lation    between      prices     and,     3; 


158 


INDEX 


causal  explanation  of  value  or 
"purchasing  power"  of,  12-16; 
theory  of  bimetallism,  16-18;  value 
of  subsidiary,  19-21;  relation  of 
value  of,  to  value  of  a  standard 
money  metal,  21-22;  relation  be- 
tween level  of  prices  and  value  of, 
in  one  country  or  locality  and  level 
of  prices  and  value  of,  in  another, 
22-24;  substitution  of  credit  for, 
26-27;  reasons  why  bank  credit 
is  able  to  displace,  as  a  medium  of 
exchange,  33  S. ;  relation  of,  to- 
gether with  bank  credit,  to  prices, 
43~4S;  substitutes  for,  in  inter- 
national and  long-distance  trade, 
52 ;  cost  of  shipment  of,  in  domestic 
exchange,  115-116. 


N 


National  banks,  guaranteeing  of  notes 
issued  by,  by  Federal  government, 
41-42 ;  foreign  exchange  business  of, 
65-66. 

Newcomb,  Principles  of  Political 
Economy,  cited,  3. 


Panics,  effect  of,  on  bank  credit,  46- 
47 ;  lowering  of  rate  of  exchange 
due  to,  113-114;  effect  of,  in  one 
country  on  discount  rate  and  flow 
of  specie  in  other  countries,  137- 
138. 

Paper  money,  exchange  between  coun- 
tries under  existence  of,  as  an  in- 
convertible standard,  142-147. 

Par  of  exchange,  77-78;  establishment 
of  a  new,  between  countries  with 
different   monetary   standards,    139. 

Place  speculation  in  exchange,  96- 
97. 

Prices,  quantitative  statement  of  re- 
lation between  money  and,  3-4; 
causal  explanation  of,  of  given  kinds 
of  goods,  5-8;  causal  explanation 
of  general  level  of,  8-1 2 ;  relation 
between  level  of,  and  value  of  money 
in  one  country  or  locality  and  level 
of,  and  value  of  money  in  another, 
22-24;   relation  of  money,  together 


with  bank  credit,  to,  43-45;  in- 
fluence of,  in  the  long  run,  on  the 
exchange  market,  11 6-1 20;  affected 
by  bank  discount  rate,  135-136; 
effect  of  a  panic  in  one  country  on 
level  of,  in  other  countries,  137-138; 
effect  on,  of  different  currencies  in 
two  different  countries,  138-142. 

Promissory  notes,  use  of,  for  money, 
26-27. 

Protection.     See  Protective  tariff. 

Protective  tariff,  effect  of,  on  rate  of 
exchange,  152. 

Purchasing  power  of  money,  a  phrase 
used  to  express  the  price  of  money, 
12-13;    explanation  of,  13-16. 


Quantity  theory  of  money,  3-4. 


R 


Rate  of  exchange,  77  ff. ;  causes  o! 
fluctuation  in,  78;  effect  on,  of 
disturbed  political  or  industrial  con- 
ditions, 83-84 ;  short  time  loans  and,  /" 
85-90 ;  upper  limit  to  fluctuation  of,  f^ 
determined  by  cost  of  exporting 
specie,  103-107 ;  lower  limit  to 
fluctuation,  determined  by  cost  of 
importing  specie,  II  i-i  13;  influence 
of  panics  or  financial  disturbances 
on,  113-114;  long  run  effects  on, 
of  a  balance  of  payments  from  one 
country  to  another,  116  ff. ;  long 
run  effect  of  international  invest- 
ments on,  120-122;  long  run  effect 
of  payments  for  various  purposes  on, 
122-124;  when  one  of  two  countries 
has  a  gold  and  the  other  a  silver 
standard,  138-142 ;  when  one  of 
two  countries  has  a  gold  and  the 
other  an  inconvertible  paper  stand- 
ard, 142-144 ;  conditions  as  to,  in 
case  of  prohibition  of  specie  ship- 
ment, 147-152;  effect  on,  of  high 
import  and  export  duties,  152. 

Rediscounting  bills  of  exchange,   71- 
72;    not  practised  in  United  States, 

72-73- 
Reserves  in  banks,  42,  44. 


INDEX 


159 


Seasonal  variations  of  trade,  desir- 
ability of  elasticity  in  bank  currency 
to  meet,  48,  50. 

Selling  short  in  foreign  exchange,  99- 
100. 

Short  time  loans  made  through  the 
exchange  market,  relations  involved 
in  and  results  of,  85-90. 

Sight  drafts,  67;  rate  on,  constitutes 
the  pure  rate  of  exchange,  126; 
relation  between  bank  discount  rate 
and  price  of,  133-136. 

Specie,  rate  of  exchange  and  the  flow  of, 
103  flf. ;  upper  limit  to  fluctuation 
of  rate  of  exchange  determined  by 
cost  of  exporting,  103-107;  details 
connected  with  exportation  of,  107- 
III ;  lower  limit  to  fluctuation  of 
rate  of  exchange  determined  by 
cost  of  importing,  111-113;  long 
run  effects  on  flow  of,  of  a  balance 
of  payments  from  one  country  to 
another,  116  ff. ;  long  run  effects 
on  flow  of,  of  international  invest- 
ments, 120-122;  effect  of  bank  dis- 
count rate  on  price  of  demand  drafts 
and  the  flow  of,  133-136 ;  flow  of, 
abroad  prior  to  outbreak  of  European 
war,  136  n. ;  effect  of  panics  on  flow 
of,  137-138;  effect  on  flow  of,  of  dif- 
ferent currencies  in  two  countries, 
138  ff. ;  exchange  between  two 
countries,  assuming  prohibition  of 
shipment  of,  147-152. 

Speculation  in  foreign  exchange,  96-100. 

Sterling  loans,  85-86. 

Stock  exchange.  New  York,  closing  of, 
to  impede  flow  abroad  of  specie, 
136  n. 

Subsidiary  money,  conditions  deter- 
mining successful  employment  of, 
19-21. 


Supply  and  demand,  relation  between 
price  of  a  given  kind  of  goods  and, 
5-8;  application  of  principles  of, 
to  the  general  level  of  prices,  8-12; 
applied  to  money  and  prices,  13-16; 
effects  of  laws  of,  on  various  mone- 
tary systems,  16;  price  of  bills  of 
exchange  or  drafts  determined  by, 
77;  forces  affecting,  of  bills  of  ex- 
change, 78-83. 


Tariffs.     See  Protective  tariff. 
Taussig,  Principles  of  Economics,  cited, 

115.  121. 
Time  drafts,  127. 

Time  speculation  in  exchange,  97-100. 
Trade,  primitive,  i ;    money  as  a  part 

of  the  mechanism  of,  1-2. 
Transportation,  cost  of,  of  money,  in 

domestic  exchange,  115-116. 


Velocity    of    circulation,    relation    be- 
tween supply  of  money  and,  13-14. 


W 


Waiting,  element  of,  provided  by  de- 
positors or  lenders,  in  commercial 
banking,  30-33- 

Walker,  Political  Economy,  cited,   13. 

Wampum,  medium  of  exchange  among 
Indians,  i. 

War,  the  European,  and  the  exchange 
market,  107;  effect  on  flow  of 
specie  to  Europe,  136  n. 

Warburg,  Paul  M.,  "The  Discount 
System  in  Europe,"  cited,  37  n. ; 
quoted,  72  n. 

White,  Money  and  Banking,  cited,  44. 


Printed  in  the  United  States  of  America. 


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